Earlier this week, ETF giant PowerShares announced a change in indexes for its popular High Yield Corporate Bond Fund (PHB). The fund will now track the RAFI High Yield Bond Index which measures potential returns of a theoretical portfolio of high yield, U.S. dollar denominated corporate bonds registered for sale in the United States whose issuers are public companies listed on a major U.S. stock exchange. The fund will now go by the name PowerShares Fundamental High Yield Corporate Bond Fund and maintain the same ticker symbol. PHB is now the first fundamentally weighted bond fund by using the increasingly popular RAFI methodology which puts a premium on the ability of a company to pay back bond interest as opposed to using a cap weighted system which tends to focus on the heaviest issuers of debt which are often the riskiest companies. “We believe the index rules that we designed and maintain for the RAFI Index provide the highest liquidity, creditworthiness, investability and interest rate risk balance for a high-yield index today.” said Ron Ryan, CEO of Ryan ALM who helped to develop the new index [also read High Yield Bond ETFs In Focus].
The new index looks to focus more on the top echelon of junk-rated bonds allocating roughly 84% to ‘BB’ and ‘B’ rated securities with the remainder going towards ‘BBB’ rated firms. By comparison, the old index offered a zero percent weighting to ‘BBB’ rated companies. The difference is even more striking when comparing the allocations that the indexes make to securities rated ‘CCC’ or lower; 11% of the old index went to these high risk securities compared to a zero percent weighting in the new index. “Traditional bond indexes are flawed. Why would you want to give the biggest portion of assets to those companies that are the biggest debtors?” said Rob Arnott, chairman and founder of Research Affiliates, LLC, which developed the new index in conjunction with Ryan ALM, Inc. “The RAFI High Yield Bond Index offers a compelling alternative to traditional high-yield bond indexes.” [also read The Coming Bond ETF Boom]
While this switch will undoubtedly help the quality level of the bonds, it is likely that the yield will fall due to the lower credit risk in the new index. By some estimates, the yield will fall roughly 50 basis points but the modified duration will also drop from 4.8 years to 4.2 years suggesting that the new index will allow for a fund which is less impacted by interest rate changes. Additionally, the number of holdings in the fund is likely to go up almost three fold since the higher quality companies tend to issue less debt forcing the index to buy a wider range of bonds instead of simply focusing in on large-debt issuers. “We believe this fundamental weighting offers a better risk adjusted profile than cap-weighted funds that tend to be more heavily concentrated in companies that issued the most debt” said Ed McRedmond the Senior Vice President of Institutional and Portfolio Strategies at PowerShares. The fund, which has over $220 million in assets and average volume over 115,000 shares, charges an expense ratio of 50 basis points and has produced a gain of 1.1% so far in 2010 [also see Junk Bond ETFs: Too Good To Be True?].
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Disclosure: No positions at time of writing.