The Next Frontier: Focusing on the “Yield” in High-Yield

High yield fixed income has come a long way over the past three decades, evolving from an investment product few would include in a typical portfolio to one that is now behind, according to Morningstar as of August 1, 2018, close to 60 exchange traded funds and a mainstay in diversified allocations. But today’s mainstream high yield products, for a variety of reasons, tend to focus on one aspect of this dynamic asset class - quality. So the next step in the evolution of high yield bond investing may be combining earlier high yield principles with new  techniques designed to maximize the yield in an effort to again deliver truly high income strategies for investors.

From Fringe Financing to General Acceptance

Before the 1980s, high yield bonds were primarily the result of debt issuers getting into financial trouble. By the mid-1980s, however, investment banks and corporate America at large began to get accustomed to the idea of high yield bonds as a legitimate source of financing — and the proliferation of issuers began. New industries such as cable television and telecommunications came to rely on new-issue high yield bonds for capital, and by the mid-1990s the instrument was stoking the leveraged buyout frenzy.

Nonetheless, investors remained cautious about including high yield bonds as a core asset in typical portfolio allocations. Their reluctance about funding entirely new business models with high yield debt was seemingly justified when the dotcom bubble burst in the early 2000s.

Active Underperformance and the Birth of High Yield ETFs

High yield debt also was viewed skeptically by some investors because, prior to the mid-2000s, it was almost exclusively actively managed within investment portfolio. The thinking at the time went that careful analysis and skillful management would unearth value in the space — but for many investors the reality often failed to meet that premise, as most asset managers struggled to consistently outperform market weighted high yield benchmarks.

The first set of high yield exchange traded funds came out in 2007, all of them passively managed. At first, active managers in the high yield space pointed to the ETFs’ full price transparency and all-day liquidity and foresaw doom-and-gloom market behavior and erratic performance. But over the next several years, these ETFs have continued to gain investor attention.

Several factors contributed to the new ETFs’ popularity. The quantitative easing introduced by the Federal Reserve in 2009 following the Great Recession pushed down yields on quality-focused debt. This led to traditional fixed income products such as Treasuries, mortgage-backed securities and investment-grade corporate debt becoming less attractive for investors looking for higher levels of income but drove some increased investor acceptance of high yield bonds as an asset class. At the same time, some investors began to pay attention to some of the benefits such as transparency and ability to trade their funds on an exchange that ETFs were beginning to exhibit versus actively managed high yield funds.

New launches in high yield ETFs stalled between 2008 and 2010 due to the Great Recession but picked back up in 2011. According to Morningstar, as of June 1, 2018, investors can choose from 57 high yield ETFs. Net flows into the ETFs, meanwhile, kept rising from 2007 until 2012, slowed between 2013 and 2015, spiked up in 2016 and fell off last year to above-2015 levels, according to Morningstar.

Exhibit-2

ETFs Boosting Market Liquidity

Many investors feel that high yield ETFs may have benefited the overall high yield debt market. Some analysts believe that their proliferation and growth has contributed to trading liquidity in the space: net flows into ETFs coincided with improved market liquidity after 2008, while a slowdown in ETF net flows between 2013 and 2015 caused a downturn in secondary liquidity during that time period. Liquidity again improved in 2016, with net flows rising.

Exhibit-3

This improved liquidity may have also benefited investors from a price discovery standpoint. Matrix pricing used by most mutual funds investing in high yield securities only provide an estimated valuation. Actual trading, on the other hand, may let investors get more immediate individual bond price information.

High yield investing has grown tremendously since its inception. According to Bloomberg, the market value of the Bloomberg Barclays US Corporate High Yield Index rose from just $43.9 billion in December 1990 to $1.3 trillion by December 2017, and from a mere 285 issues in 1990, to 2,043 by the end of 2017.

Along the way, however, a major market event transformed the way high yield market-weighted indexes were composed. When General Motors and Ford Motor were downgraded to junk status in May 2005, the high yield bonds from the two issuers accounted for 11.8% of the index exposure. This caused providers to scramble for the release of issuer-constrained market-weighted indexes, such as the Bloomberg Barclays U.S. High Yield 2% Issuer Constrained Index. Capping any individual company exposure at 2% of the index was meant to address risk arising from the potential for company-specific overexposure.

While the issuer cap appears to benefit some investors, it may actually undermine one of the key factors for others that makes high yield bonds attractive in the first place: the ability to generate higher yields through higher risk exposure.

Regaining the Income Potential of High Yield Investing

Fixed income typically plays a dual role in portfolio allocation. On the one hand, it provides diversification. But it is also meant to generate income — which is a function of yield. Analysis by the Northern Trust Asset Management Fixed Income Group of the Bloomberg Barclays US High Yield Index shows that analysis of historical return components indicate that, in order to maximize the value of high yield as an investment, investors should consider focusing on maximizing exposure to yield in constructing and managing their high yield portfolios.

That has, however, not been the case for some investors. Mainstream high yield investing has become focused on the single issue of quality, which for some portfolios has produced a lower-yielding investment in the process. By focusing on quality, investors may be missing out on the income generation potential of high yield bonds. Therefore, for many investors searching for higher income investing opportunities the next step in the evolution of high yield bond investing may actually be focusing on the yield of their high yield investments.

DOWNLOAD WHITE PAPER: “The Evolution of High Yield Bond Investing”

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Before investing, carefully consider the FlexShares investment objectives, risks, charges and expenses. This and other information is in the prospectus and a summary prospectus, copies of which may be obtained by visiting www.flexshares.com. Read the prospectus carefully before you invest.

Foreside Fund Services, LLC, distributor.

An investment in FlexShares is subject to numerous risks, including possible loss of principal. Fund returns may not match the return of the respective indexes. A full description of risks is in the prospectus.

FlexShares High Yield Value-Scored Bond Index Fund (HYGV) invests in high yield securities, which are considered highly speculative, and is subject to greater credit risk, price volatility and risk of loss than if it invested primarily in investment grade securities.  There is a higher risk that an issuer will be unable to meet principal and interest rate payments on an obligation and may also be subject to more substantial price volatility due to such factors as interest rate sensitivity, market perception of credit worthiness of and general market liquidity than if the fund invested in investment grade securities. The fund may invest in distressed securities, which generally exposes the fund to risks in addition to investing in non-investment grade securities. These risks can adversely impact the Fund’s return and net asset value. When interest rates rise, the value of corporate debt can be expected to decline. The value of the securities in the Fund’s portfolio may fluctuate, sometimes rapidly and unpredictably at a greater level than the overall market. The Fund may invest in derivative instruments. Changes in the value of the derivative may not correlate with the underlying asset, rate or index and the Fund could lose more than the principal amount invested. The Fund will concentrate its investments (i.e., hold 25% or more of its total assets) in a particular industry or group of industries to approximately the same extent that the Underlying Index is concentrated.  The fund is also subject to the risk that the Fund’s investment in companies whose securities are believed to be undervalued will not appreciate in value as anticipated.

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