The world of bond exchange-traded funds (ETFs) is on the cusp of a significant transformation, and it's an exciting development for investors. While market, credit, and duration risks are key factors in bond market performance, the strategic-beta bond ETF space has been relatively limited compared to its stock ETF counterpart. However, with growing interest and improved data accessibility, the landscape is evolving.
But here's where it gets controversial: the challenges of factor investing in the bond market are substantial. Many bonds trade infrequently, and accessing their prices can be a hurdle. The complex nature of debt structures makes the bond market less transparent than the stock market.
Despite these obstacles, opportunities exist, and they're becoming more accessible. The adoption of electronic trading platforms has enhanced the accuracy of bond prices, and the Trade Reporting and Compliance Engine database has increased transparency for bond transactions. These advancements have opened doors for strategic-beta ETFs to enter the bond market.
Certain sectors are more conducive to this shift than others. High-yield corporate bonds, with their higher issuer-specific risks and fewer trading opportunities, are prime candidates for factor investing compared to government bonds or investment-grade credit.
Now, let's delve into the concept of quality as a common factor in strategic-beta high-yield ETFs. Most of these ETFs take one of two approaches: screening out distressed issuers to identify quality beyond backward-looking credit ratings, or maximizing yields while managing risk.
Exhibit 1 showcases four of the largest strategic-beta bond ETFs in the high-yield bond Morningstar Category. All four ETFs initiate their process by evaluating balance-sheet metrics at the issuer level to filter out companies with deteriorating fundamentals.
IShares High Yield Systematic Bond ETF (HYDB) and FlexShares High Yield Value-Scored Bond ETF (HYGV) calculate proprietary composite scores to assess an issuer's financial health, combining balance-sheet data with stock market prices. WisdomTree US High Yield Corporate Bond ETF (QHY) excludes issuers with poor free cash flow, except for those with strong momentum or recent positive stock returns. All three ETFs employ a value tilt to weight their constituents.
Invesco Fundamental High Yield Corporate Bond ETF (PHB) stands out by not considering recent price activity in its fundamental scoring. Instead, it relies on an issuer's sales, book value, dividends, and cash flow to determine its fundamental score, which is then used to weight its holdings.
PHB's approach of weighting by fundamentals sets it apart. It can shift the ETF towards companies with stronger fundamentals, potentially highlighting higher-quality bonds. However, these metrics have limitations. While they can identify issuers with deteriorating fundamentals whose bond prices haven't caught up, they don't capture the full risk spectrum for individual bonds.
PHB also excludes bonds rated below B and includes those straddling the BBB and BB threshold between investment-grade and high-yield. As a result, this ETF tends to be safer than its category index and average peers.
Bonds from the same company are not interchangeable, unlike stocks. An issuer's credit rating typically influences the bond's credit rating, but it's just one aspect of their risk profile. Issuer-level data doesn't capture a bond's yield, duration characteristics, or potential mispricing.
PHB's fundamental scoring protected it during recent credit stress periods, such as March 2020, but it struggled to keep up with returns during subsequent rebounds. While it has other quirks, its underperformance since inception can be attributed to its simplistic approach.
Moving beyond issuer-level metrics, the other three ETFs on the list aim to offer more than just a baseline credit risk screening. They utilize bond-level spreads and valuations data to tilt their portfolios towards more attractively valued names. HYDB and HYGV employ optimizers to maximize their portfolios' value tilts, measured by default-adjusted spreads for HYDB and a composite score for HYGV. QHY takes a simpler approach, ranking bonds by default-adjusted spreads within their sector and excluding lower-ranking ones while doubling down on cheaper issues.
While these ETFs paint a similar picture, small differences in their methodologies can lead to meaningful variations in their final portfolios.
HYDB keeps its active risk in check by tethering its duration and credit risk to its broad-market starting universe. This approach allows it to hunt for attractively priced bonds while staying within the broad contours of credit and duration risk. Since its inception in 2017, HYDB has managed to capture less of the index's downside during major stress periods and squeeze out slightly more gains during credit rallies.
In contrast, HYGV's looser constraints have allowed it to take on substantial credit risk. Its stake in bonds rated below B has consistently remained above 20% since its inception, double that of the category index. While the ETF has reduced these risks in recent years as credit spreads tightened, it suffered significant returns during the 2022 market meltdown and the March 2020 pandemic shock.
QHY also doesn't align its risk/reward profile with the broader high-yield market. As a result, its weighting scheme and stock momentum screen have led to noticeable portfolio tilts. For instance, the fund's average duration was around 0.5 years longer than the category index for most of 2023 and 2024, which didn't bode well when long-term yields spiked in September and October 2023.
Looking ahead, most strategic-beta bond ETFs still rely on publicly available stock data to construct their portfolios. As bond-level data becomes more accessible, we may see more innovative approaches emerge. While trading over the phone may persist, electronic platforms are increasingly dominating bond transactions, improving the speed and efficiency of pricing bonds.
Leveraging data effectively can bring portfolios closer to the labor-intensive credit research process that active managers have traditionally used to their advantage. It could also broaden the scope of strategic-beta bond ETFs, as issuer-level data currently limits the eligible scope to public issuers with readily available and accessible balance sheets and stock prices.
As more of these ETFs enter the market, investors should remember the lessons from the pioneering efforts discussed above: understand the active risks the fund takes and keep an eye on any stray bets.
The author(s) do not own shares in any securities mentioned in this article. For more information on Morningstar's editorial policies, please visit https://www.morningstar.com/editorial-policy.
