Strategic beta strategy closes the gap between investment grade and high-yield ETFs

Apr 6th, 2018 | By | Category: Fixed Income

By Amanda Rebello, head of passive distribution, UK and Ireland, at Deutsche Asset Management.

Amanda Rebello, head of passive distribution, UK and Ireland, at Deutsche Asset Management.

Amanda Rebello, head of passive distribution, UK and Ireland, at Deutsche Asset Management.

US bond market investors have a wide choice of indices of sufficient market size. However, many investors are faced with a dilemma: USD-denominated investment grade corporate bond indices are popular because they combine the liquidity of a large, mature asset class with the security of an investment-grade rating and attractive interest rates. On the other hand, emerging market government bonds or high-yield corporate bonds offer significantly higher returns, albeit with noticeably higher risk profiles, particularly for high-yield corporates.

So what alternatives are there for investors looking for higher yields who also want the high credit rating provided by the USD bond segment? Corporate bonds with investment grade ratings from Asia are one possibility. Their credit risks are comparable with their counterparts from industrialised countries, considering their slightly shorter duration. In principle, this also applies to quality-weighted indices of emerging market government bonds, whose constituents are selected and/or weighted according to the financial quality of their issuers.

Nevertheless, many investors still want to invest in US dollars. They may also have to comply with relevant investment regulations.

Strategic index approaches may be one way of achieving a yield premium. These include the corporate yield-plus strategy, which produces higher returns without significantly increasing risk. The strategy provides investors with access to a higher credit risk premium, with lower interest rate risk than traditional ETFs.

The depth of the USD Corporates asset class makes it possible to use this kind of strategic index approach to select bonds with higher yields and/or spreads. Two factors should be taken into account.

First, the focus lies on the segment of the US dollar corporate loan market with the highest interest rates and an investment grade rating. Second, unlike traditional indices, bonds that lose their investment grade rating (“fallen angels”) are not excluded from a yield-plus strategy. Academic research shows that a buy-and-hold approach can result in appreciably higher returns, though investors should be aware that the strategy includes a limited number of bonds that do not have a high credit rating.

The success is measurable. Currently, a yield-plus strategy in USD corporate bonds provides a yield premium of 55 basis points over corporate loans with an investment grade rating. In return, greater fluctuations in spread and slightly higher average bid/offer spreads have to be expected. In addition, the yield-plus strategy benefits from lower sensitivity to interest rates than most ETF indices for corporate loans with good credit ratings.

Conclusion: Strategic Beta approaches have become established in the bond segment. A yield-plus strategy offers an interesting alternative to traditional, so-called “core” benchmark indices for corporate loans, particularly as their valuations are attractive and the duration is similar. Investors seeking returns could concentrate on higher-yielding bonds in the traditional investment-grade benchmarks to increase yield at limited costs in terms of diversification and duration.

(The views expressed here are those of the author and do not necessarily reflect those of ETF Strategy.)

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