HYG - Consider Selling HYG And Buying SPHY Or USHY Instead

2023-12-24 05:26:02 ET

Summary

• HYG is the largest high-yield bond ETF in the market.
• It is not a particularly good choice.
• A look at the fund, and some better alternatives, follows.

The iShares iBoxx $ High Yield Corporate Bond ETF ( HYG) is the largest high-yield bond ETF in the market, with $19.2 billion in AUM. It is also one of the most expensive ones, with a 0.49% expense ratio. HYG does not really have any significant advantages over its peers, including the SPDR Portfolio High Yield Bond ETF ( SPHY ) and the iShares Broad USD High Yield Corporate Bond ETF ( USHY ), but is much more expensive. Said expenses have led to underperformance in the past and will, I believe, lead to further underperformance in the future. As such, I would sell HYG, and invest in either SPHY or USHY.

HYG - Basics

• Sponsor: Investment Manager
• Underlying Index: Markit iBoxx USD Liquid High Yield Index
• Expense Ratio: 0.49%
• Dividend Yield: 5.76%
• Total Returns 10Y: 3.11%

HYG - Overview and Analysis

Index and Holdings

HYG is a simple high-yield corporate bond ETF, tracking the Markit iBoxx USD Liquid High Yield Index . It is a relatively simple index, including all bonds with the following characteristics:

• fixed-rate
• developed market corporate issuer
• dollar denominated
• non-investment grade credit rating, BB or lower

As with most other indexes, there are certain other basic inclusion and exclusion criteria centered on liquidity, size, and the like.

HYG provides investors with diversified exposure to high-yield bonds, with investments in 1,188 bonds from all relevant industry segments.

Concentration is quite low too, with most issuers accounting for less than 1.0% of the fund's portfolio, none for more than 3.0%.

HYG's diversification reduces risk, volatility, and potential losses from any one individual default. These are all important benefits, and of particular importance for a high-yield bond fund.

Besides the above, nothing really stands out about HYG or its underlying index. It is a broad high-yield corporate bond index ETF, with a reasonable index, and with holdings reflective of the same.

Importantly, the fund's index and portfolio does not markedly differ from several of its peers, including SPHY and USHY. There are some differences, with both SPHY and USHY having somewhat laxer inclusion criteria and more diversified portfolios, but these are small differences, all things considered.

Credit Risk

HYG focuses on non-investment grade bonds, with an average credit rating of BB.

HYG's credit ratings are indicative of relative weak issuers, with subpar financials and balance sheets. Nevertheless, these companies can generally meet their financial obligations, with long-term average default rates of 3.6%.

On the other hand, default rates are somewhat dependent on economic and industry conditions, with many non-investment grade issuers defaulting during recessions, downturns, or similar environments.

Right now, higher interest rates have make it difficult and prohibitively expensive for some of the riskier issuers to roll-over their debt. Default rates have increased to around 4.1% , slightly higher than average. Defaults could continue to increase if rates remain higher for longer, especially as older bonds, issued with lower rates, continue to mature.

Default rates also spike during recessions and downturns, one can see the impact of the pandemic in the graph above. High-yield bond prices tend to follow suit, leading to losses and underperformance during these. As an example, HYG saw double-digit losses during 1Q2020, the onset of the coronavirus pandemic. Losses were much higher than those of most bonds and bond sub-asset classes.

HYG's credit quality is very slightly higher than that of most high-yield corporate bond ETFs, due to slightly stricter inclusion criteria. Differences are small, however.

Risks and drawdowns seem comparable. Losses were slightly higher during 1Q2020, but recovered slightly faster during 2Q2020 too. Differences here seem small, and mostly due to volatility, however.

Dividends and Dividend Growth Analysis

HYG focuses on non-investment grade bonds, with high credit risk and yields. HYG itself yields 5.8%, a somewhat good yield, and higher than that of most bonds and bond sub-asset classes.

Although HYG's 5.8% dividend yield is accurate, it does not fully take into consideration recent Fed hikes. The fund's 8.3% yield to maturity is a more forward-looking yield metric, and much more indicative of the dividends and returns that investors should expect moving forward. In my opinion at least.

On the other hand, HYG's dividends compare somewhat unfavorably to those of USHY and SPHY. Both funds have higher dividend yields:

But more comparable yield to maturities:

HYG's lower dividend yield is at least partly the result of its much higher expense ratio. HYG has expenses of 0.49%, while USHY is cheaper at 0.15%, SPHY even cheaper at 0.05%. Dividends are net of fees, so higher expenses directly reduce fund dividends.

On a more negative note, if the Federal Reserve were to cut rates in the coming years, as seems exceedingly likely, dividends for these funds would all likely decrease. The magnitude and timing of these (potential) dividend cuts would depend on the magnitude and timing of any potential rate cuts, however.

Performance Analysis

Bonds are income vehicles, whose long-term returns are almost entirely dependent on income. Due to this, HYG should outperform relative to most bonds and bond sub-asset classes long-term, as has been the case since inception:

On the other hand, as the fund yields than comparable high-yield bond ETFs, it should underperform relative to these long-term, as has been the case since inception:

HYG is a bit more expensive than SPHY and USHY, and so has a lower yield and total returns. This is an important negative for the fund. Importantly, HYG does not significantly differ from these two funds otherwise, with comparable indexes, credit ratings, drawdowns and risk. The only important difference between these funds is HYG's higher expenses, which means there is more or less no reason to expect HYG to ever outperform, or to buy the fund. SPHY and USHY seem strictly better, in my opinion at least.

Conclusion

HYG is a simple high-yield corporate bond ETF. Although there is nothing significantly wrong with the fund, it is somewhat more expensive than its peers, leading to lower dividends and weaker performance. As the fund does not really have any significant advantages over its peers, I would not invest in the fund.

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