FDHY - FDHY: 7.5% Yield Monthly Dividend From An Outperforming Corporate Bond ETF

2023-11-23 06:53:15 ET

Summary

• The Fidelity High Yield Factor ETF offers exposure to corporate bonds through an actively managed strategy.
• The fund has outperformed peer benchmarks historically.
• Narrowing credit spreads and a resilient economic backdrop highlight tailwinds for this market segment into 2024.

The Fidelity High Yield Factor ETF ( FDHY ) invests in corporate debt securities rated below investment grade. The attraction of this segment is the potential for strong risk-adjusted returns while also capturing a "high yield".

In this case, FDHY stands out with its actively managed strategy where the portfolio management team at Fidelity attempts to screen for the best opportunities and ultimately beat its benchmark. Favorably, FDHY has outperformed peer funds since its inception despite facing a volatile period in 2022 amid rising interest rates but gaining momentum more recently.

We highlight a trend of narrowing credit spreads with signs the U.S. economy can avoid a recession as a tailwind for high-yield bonds going forward. We like FDHY for its unique exposure and compelling 7.5% yield through a monthly distribution.

What is the FDHY ETF?

FDHY uses the "ICE BofA BB-B US High Yield Constrained Index" as the starting point for its universe of eligible securities. Through a proprietary multifactor quantitative model , the fund filters over 1,000 bonds to identify and select the best opportunities between return potential and low probability of default following value and quality-factor-based methodology.

The idea here is that instead of simply "tracking" the benchmark, FDHY attempts to at least exclude some of the bad apples while outweighing the stronger names. At the same time, the current portfolio across 348 holdings or 276 issuers means there is a good measure of diversification, where the overall performance ends up reflecting the high-level trends of this market segment, more so than the returns of a single issuer.

Going through the portfolio metrics, the average bond credit quality is 53% in B-rated and 42% in BB-rated corporate bonds. The maturity profile can be described as an intermediate strategy where nearly 45% of the duration distribution is between 3 and 5 years. This means that FDHY has otherwise modest interest rate risk, with credit spreads being a more critical component of the risk profile.

Beyond the term "junk bonds", the takeaway here is that the underlying exposure across high-yield and the FDHY portfolio is composed of major corporations covering all sectors.

Among the top holdings, we find debt securities from names like Northern Oil and Inc ( NOG ), Royal Caribbean ( RCL ), Ford Motor ( F ), Sunoco LP ( SUN ), and Iron Mountain ( IRM ) as some examples. While there are mostly U.S. companies, the understanding is that most have global exposure considering international operations.

FDHY's monthly distribution has climbed over the past year, alongside rising interest rates. The latest dividend of $0.29 per share represents a forward yield of 7.5% with Fidelity listing a 7.9% 30-day SEC yield as a standardized reference point. The understanding is that each payout is variable based on the underlying interest income.

FDHY Performance

We mentioned that FDHY has outperformed comparable high-yield ETFs historically since the fund inception date in June 2018. That being said, the relative performance has been mixed more recently.

FDHY has returned 7.2% over the past year, which is just about average compared to alternative funds like the SPDR Bloomberg High Yield Bond ETF ( JNK ) with a 7.7% or the iShares High Yield Bond Factor ETF ( HYDB ) with a strong 10% return over the period.

The point here is not to say FDHY is always "the best" fund or will lead higher over every period, but we believe it does a good job within this category.

What we do want to highlight is that FDHY performed particularly well between 2020 and 2021. The fund returned 15.5% over this period, well ahead of the second-strongest fund from this group. Our interpretation is that the fund's strategy benefits from favorable market conditions meaning the fund should also perform well into the next bond bull market. In other words, we believe FDHY is well-positioned to outperform the upside, which could be the case going forward into 2024.

What's Next For FDHY?

Several recent developments support a positive outlook for corporate bonds and fixed income overall. Importantly, signs of ongoing disinflation including the latest CPI report for October that surprised to the downside have helped to build a consensus that the Fed is done hiking rates and even opened the door for potential rate cuts into 2024.

This is particularly bullish for high-yield in the context of what has been resilient economic conditions, brushing aside fears of a looming recession. What we're seeing here is the emergence of the "soft landing" scenario where the Fed has been successful at stabilizing inflation with only limited disruptions to the economy.

This backdrop translates into a declining risk of default for high-yield corporates which we have seen reflected in narrowing credit spreads.

The chart below tracks the "ICE BofA BB US High Yield Index Option-Adjusted Spread" as a proxy for credit risk , essentially implying the additional spread above risk-free Treasuries the market is demanding to hold junk bonds.

Historically, environments where the spread is widening, such as during the initial pandemic crash or the great financial crisis, are a more concerning headwind for corporate bonds we're just not seeing right now.

The path over the past year has been a narrowing spread as a performance driver for FDHY we expect to continue. Overall, FDHY should continue delivering positive returns into 2024 as a continuation of the current environment.

Final Thoughts

FDHY is a high-quality fund that is a good choice for investors to capture exposure to this important market segment. The actively managed strategy within corporate bonds has a solid history which we believe justifies the 0.45% expense ratio.

In terms of risk, a scenario where interest rates climb significantly higher, potentially based on an unexpected rebound to inflation, would drive some renewed volatility to this market segment. Similarly, a deterioration of economic conditions, pushing credit spreads wider, would open the door for a broader selloff in corporate credit bonds.

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