HYLS - HYLS: Even With An 8+% Yield This Junk Bond ETF Isn't Worth It

2023-07-03 03:21:22 ET

Summary

• First Trust Tactical High Yield ETF holds a significant percentage of low-rated junk bonds that have high default rates, especially during economic downturns.
• The junk bond spread over 10-year treasury bonds is below the historic trend line, suggesting that the risks of junk bonds are not adequately priced in.
• I rate HYLS a Sell.

First Trust Tactical High Yield ETF ( HYLS ) offers investors exposure to high-yield (junk) bonds. HYLS has AUM of about $1.5B and has a 30-day SEC yield of about 8.1%. While this yield may seem enticing, I don't think the risk is worth it considering that I think we will likely enter a recession in the near future. Not only does HYLS give investors a bad risk-reward ratio, but it also charges a high fee to do so. I rate HYLS a Sell.

Holdings

HYLS holds 311 bonds, a relatively low number of holdings compared to other bond ETFs. HYLS's top 10 holdings account for about 26% of its AUM.

This ETF has pretty good diversification among sectors. HYLS is heavily concentrated in the financial industry, but that is typical for bond ETFs.

Credit Ratings

Recently, I've recommended a Buy for two ETFs that hold junk bonds. In my article on HYBB , I argue that because HYBB holds higher-quality junk bonds, an investor can get a higher yield but not have as much default risk as a junk bond ETF that holds mid and low-rated junk bonds. In my article on JPIE , I argue that it holds higher quality junk bonds and mixes that with AAA-rated bonds limiting some of the volatility and default risk. I bring this up because I want to distinguish between highly-rated junk bonds from the low-rated junk bonds that HYLS holds.

HYLS holds over 26% of its AUM in CCC tier bonds (CCC+ to CCC-).

CCC bonds are truly "junk" bonds. To put this into context , between 1994 and 2015, CCC bonds averaged an over 11% default rate, while the B-rated bonds, the notch up from CCC, only averaged a 2.8% default rate. While B-rated bonds look good compared to CCC bonds, a nearly 3% default rate is still high. Plus, I expect junk bond default rates to be higher than the historical average in the next couple of years as we enter a recession.

Junk bond outlook

Junk bonds in general have a higher default rate than investment-grade bonds, of course, but during times of economic contraction, junk bonds take an even harder hit. With Interest rates being raised so quickly all the way to a two-decade high, and with more rate hikes to come, I strongly believe that the US is headed into a recession. Inflation has remained sticky, and the Fed seems not to be afraid to push the economy into a recession to bring it back down. Investors are still waiting for another two rate hikes in 2023 forecasted by Fed Chairman Powell. This will cause strain on the economy, hurting most companies, but especially junk bond issuers. Companies whose bonds get junk bond ratings are already financially unstable and highly indebted, and adding the extra pressure of a recession makes them even more likely to default. I'm not the only one predicting this increase in defaults. The image below shows Barclays' default rate forecast .

With all this economic uncertainty and the possibility of a recession on the horizon, it's reasonable to assume that junk bonds must be paying a higher yield compared to ordinary times. Surprisingly, the junk bond spread over 10-year treasury bonds is actually below the historic trend line.

Looking at the chart above, you would assume we are experiencing typical economic conditions, but we obviously aren't. So not only does HYLS give you exposure to very low-rated bonds, but its risk-reward ratio is also inadequate.

Expense ratio

Another reason to stay away from HYLS is its high expense ratio. Its current expense ratio is 1.27%. This expense ratio isn't warranted. HYLS has not produced results that justify this price.

In the past 3 years, HYLS has underperformed JNK , a junk bond index, by about 3%. JNK's expense ratio is only .40%.

Conclusion

While this ETF has a very impressive 30-day SEC yield of about 8.1%, I don't think this is high enough to justify all the risk. The junk bond spread over 10-year treasury bonds shows that junk bond investors aren't yet pricing in a recession. The very low-tier bonds that HYLS holds will likely suffer from higher default rates in the recession that I see on the horizon. The extremely steep expense ratio of 1.27% is just another reason not to own this ETF. Because of all this, I rate HYLS a Sell.

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