HYLS - HYLS: Strong High-Yield Corporate Bond ETF 6% Yield

2024-01-11 13:24:41 ET

Summary

• HYLS offers a 6.0% yield and has outperformed most peers since inception.
• HYLS is riskier and pricier than its peers, with a 1.27% expense ratio.
• I rank HYLS as a buy, but I think there is a better alternative.

The First Trust Tactical High Yield ETF ( HYLS ) is an actively-managed high-yield bond ETF. HYLS offers investors a solid 6.0% yield, has outperformed most of its peers since inception, and with above-average expected returns/yield to maturity as well. On the other hand, it is riskier than most of its peers, and pricier, with a 1.27% expense ratio. I rate the fund a buy, but the SPDR Portfolio High Yield Bond ETF ( SPHY ) seems like a similar, slightly superior alternative.

HYLS - Basics

• Investment Manager: First Trust
• Dividend Yield: 6.04%
• Expense Ratio: 1.27%
• Total Returns CAGR 10Y: 3.61%

HYLS - Overview and Analysis

Portfolio and Holdings

HYLS is an actively-managed ETF focusing on U.S. high-yield corporate bonds, with smaller investments in loans and other assorted fixed-income securities.

HYLS is a reasonably well-diversified fund, with investments in over 300 securities from most relevant industry segments.

Broad-based high-yield corporate bond ETFs tend to be even more diversified, with the benchmark iShares iBoxx $ High Yield Corporate Bond ETF ( HYG ) investing in over 1,000 securities.

HYLS sometimes uses leverage, to boost income and returns. Leverage ratios declined between late 2021 and early 2022, almost certainly as a reaction to higher interest rates/lower bond prices. Leverage currently stands at 1.03x, a very low, conservative figure.

HYLS's leverage slightly increases portfolio risk, volatility, and losses during downturns. The overall impact is quite small, however, as leverage ratios are quite low.

High Credit Risk

HYLS focuses on non-investment grade bonds and loans, with these encompassing around 85% of its portfolio. There are sizable allocations to comparatively safe investment-grade bonds and very risky CCC bonds. This is likely due to the fund's management team focusing on bonds (perceived to be) particularly attractive or high-yielding, regardless of their credit rating.

HYLS's portfolio is much more spread out than average, with most high-yield bond ETFs focusing on bonds rated BB and B. In particular, high-yield index funds are generally constrained from investing in investment-grade bonds, and are market-value weighted, so allocations to the riskiest bonds are comparatively low (most bonds have higher ratings). For reference, HYG's credit ratings.

In my opinion, and considering the above, HYLS has slightly lower credit quality than average. Due to this, and due to leverage, the fund should see above-average losses during downturns and recessions. This was not the case during 1Q2020, the onset of the Covid pandemic. The fund saw comparable losses peak to trough during the pandemic, and a slightly faster recovery than average. Losses were higher than those of bonds in general, but lower than those of the S&P 500.

In my opinion, the fact that HYLS did not see above-average losses during 1Q2020 is evidence of management's capacity to select appropriate, best-performing securities with higher-than-expected returns and quality. A leveraged fund with significant allocations to CCC bonds could have very easily seen brutal, long-lasting losses during the pandemic. HYLS did not, so management seems to be selecting reasonable securities and constructing decent portfolios, low credit ratings notwithstanding.

Dividends and Dividend Growth

HYLS's non-investment grade bonds are quite risky, but also high-yielding, with the fund itself sporting a 6.0% dividend yield. It is a good yield on an absolute basis, much higher than that of most bonds and bond sub-asset classes.

On a more negative note, the fund's dividend growth track-record is quite mediocre, with HYLS seeing zero long-term growth, and significant dividend cuts these past twelve months.

Recent dividend growth has been much lower than average, with almost all bond funds seeing significant dividend growth since early 2022, due to Fed hikes. For reference, HYG's dividends have grown 17.9% these past twelve months.

HYLS's recent dividend growth has been terribly weak for two main reasons.

First, the fund has decreased its use of leverage. Less leverage means less assets, which means less income and dividends.

Second, the fund's dividends saw significant growth from early 2021 to late 2022, almost certainly due to fund positioning: HYLS focused on bonds with particularly high yields, leading to dividend growth. Positioning has shifted once more, as have dividends. The medium-term trend is definitely towards higher yields, but not readily apparent in the data.

Moderate Potential Capital Gains

For HYLS, long-term total returns will mostly consist of dividends, but investors might see some moderate capital gains as well. This is because the fund holds tons of older corporate bonds, whose prices declined as the Federal Reserve hiked rates, but which will be repaid in full at maturity.

As per HYLS, the fund's underlying holdings trade at an 8.1% discount to par, with an average maturity of 5.2 years. By my calculations, that amounts to 1.6% in potential capital gains per year, a reasonably good amount considering this is an income fund.

Some funds publish their yield to maturity, equivalent to the expected returns from holding a bond until maturity. Said metric includes both dividends and potential capital gains, and currently stands at 8.4%.

HYLS's 8.4% yield to maturity is quite strong, and higher than that of most broad-based bond index ETFs.

Importantly, the fund has the highest yield to maturity out of all high-yield corporate bond ETFs I've seen, including most of the larger, well-known ones.

Considering the above, I think it is fair to say that HYLS's moderate potential capital gains lead to the highest expected returns within its peer group. Returns could always fail to materialize, due to adverse economic conditions or bad investment decisions. Still, prospective returns are quite strong.

Low Interest Rate Risk

HYLS focuses on non-investment grade corporate bonds. These tend to have relatively short maturities, as investors are loathe to extend long-term credit to riskier issues. The fund currently sports a weighted average maturity of 5.3 years, duration of 3.7 years. Both figures are low on an absolute basis, lower than average for a bond fund, but average for a high-yield corporate bond fund.

Due to the above, HYLS tends to outperform when interest rates increase, as has been the case since early 2022.

The flipside of the above is that HYSL should see lower capital gains as interest rates stabilize. This might lead to underperformance, but the fund's above-average yield might overcome these issues.

Importantly, the market is expecting moderate rate cuts already, and are pricing bonds accordingly. Due to this, moderate rate cuts might not necessarily have a significant impact on bond prices, nor lead to underperformance. Significant rate cuts would almost certainly have that impact, at least if these occur in the next few months.

Performance Track-Record

HYSL's performance track-record seems about average, but there are some important caveats.

Long-term returns are slightly higher than average. Most of the fund's outperformance occurred prior to 2022, due to a combination of leverage and management alpha. Outperformance was halved in 2022, mostly due to leverage. The fund has since decreased their use of leverage, and continues to slightly outperform. One can see the entire process play out when comparing HYLS's returns to those of HYG.

In my opinion, HYLS's performance seems reasonable enough, especially considering the fact that the fund has reduced its use of leverage, which means the losses and underperformance of 2022 are unlikely to repeat themselves.

Expense Ratio

Finally, the fund's 1.27% expense ratio is quite high, and almost five times as high as that of the average high-yield corporate bond ETF. One of these, SPHY, sports a 0.05% expense ratio, more than 1.0% lower than that of HYLS.

HYLS's expenses directly reduce fund dividends and returns, and are the fund's most significant drawback.

In my opinion, the fund's strong, above-average yield to maturity and performance track-record outweigh its expense ratio, and so the fund is a buy. Nevertheless, I feel that the fund compares unfavorably to SPHY on net. SPHY has a much lower 0.05% expense ratio, a marginally lower 8.1% yield to maturity, and equivalent total returns at somewhat lower risk and volatility.

To expand a bit on the above, I think that choosing a cheaper fund than HYLS is best, but HYLS seems reasonable enough too. HYLS's management has managed to generate more than sufficient income and returns to cover their fees in the past, consistently enough that I believe this will continue to be the case moving forward. Avoiding these issues by choosing a cheaper fund does seem like the better choice, but not by enough to warrant a hold or sell rating.

Conclusion

HYLS offers investors a solid 6.0% yield, has outperformed most of its peers since inception, and with above-average expected returns/yield to maturity as well. I rate the fund a buy, but the SPDR Portfolio High Yield Bond ETF SPHY seems like a similar, slightly superior alternative.

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