PHB: Different Kind Of Junk Bond ETF

by on September 15, 2010 | ETFs Mentioned:

The impressive ETF boom of the last several years has in many ways changed the investing landscape quite dramatically. Although index mutual funds have been around for more than 30 years, the introduction of low-cost ETFs has many investors questioning the merits of pricey active management [see Two Cases Against Active Management]. The introduction of commodity ETPs has made natural resource exposure widely available. And as indexes have been transformed from hypothetical measures of performance to (essentially) investable assets, the construction and maintenance methodologies for these benchmarks has attracted increased scrutiny. 

Much of the discussion related to the merits of various index creation techniques has taken place in the equity arena, where the wisdom of giving the biggest allocations to stocks with the largest market capitalizations has been a hot topic. And ETFs have helped to make several alternatives, including revenue weighting, earnings weighting, and equal weighting, more popular. But the indexing methodologies behind popular bonds ETFs has also been the subject of some discussion and innovation. The popular Barclays Capital U.S. Aggregate Bond Index–which is linked to BND, AGG, and LAG–contains more than 8,000 securities, many of which are very thinly-traded. So replication of that index simply isn’t practical, and ETFs based on this benchmark generally only hold a fraction of the index’s total holdings. To some, replication techniques seem like a watered-down version of active management.

In the high yield corner of the fixed income universe, some astute investors have noted that indexes behind some popular products give the largest weightings towards the biggest issuers of junk bonds. Focusing most heavily in those companies that maintain the most significant debt burdens doesn’t carry intuitive appeal as an investment strategy–generally speaking companies with larger debt burdens will have a harder time repaying obligations–but that’s exactly what some fixed income funds effectively do.

PHB: Fundamental Appeal

When PowerShares announced earlier this year that it was changing the index underlying its junk bond ETF from the Wells Fargo High Yield Bond Index to the RAFI High Yield Bond Index, the move didn’t attract much attention. But the shift wasn’t purely an administrative one, as the new underlying index utilizes a unique methodology that distinguishes PHB from the other junk bond ETFs on the market [also read Investors Can't Get Enough Of Junk Bond ETFs].

The RAFI methodology, which has been embraced by several equity ETFs, was developed by Research Affiliates, the firm founded by respected investor Rob Arnott. In short, the idea is to break the link between the price of the securities and the weight they receive in the index. As such, weightings in RAFI indexes are determined not by the size of a debt issue or market cap, but by fundamental factors. In the case of the RAFI High Yield Bond Index, weightings afforded to underlying bonds are based on four factors: book value of assets, gross sales, gross dividends, and cash flow–each based on five-year averages. So instead of giving the largest allocations to the biggest issuers of junk bonds, the underlying index is maintained in a manner that will tilt holdings towards debt issued by higher quality firms [see Junk Bond ETFs: Too Good To Be True?].

30-Day SEC Yield* 6.62% 8.23% 8.08%
% Assets BB- or Better* 60.6% 35.7% 36.4%
*As of 9/10/2010

The appeal of such a methodology is obvious; firms with greater net assets and cash flows should generally be better able to repay their debt, reducing some of the often substantial credit risk associated with junk bonds. There is, of course, a tradeoff for this reduction in risk: lower yield. Though it may be easy to group PHB and the other two funds in the High Yield Bonds ETFdb Category together, a closer look reveals that PHB maintains a unique risk/return profile.

PHB is in a sense an oxymoron: a high quality junk bond ETF. About 60% of the underlying assets are rated BB or higher, compared to only about 35% for the other junk bond ETFs on the market. In exchange for that step-up in quality is a step-down in yield; the 30-day SEC yield of PHB is about 150 basis points below JNK and HYG. At more than 6.6%, PHB definitely still qualifies as a “high yield” ETF, but one with lower risk than some of its counterparts.

That makes it a potentially intriguing option for investors looking to enhance the current return of their portfolio but hesitant to take on too much risk in fixed income holdings. Think of PHB as a more moderate junk bond ETF, falling somewhere between JNK and LQD, the ultra-popular investment grade corporate bond ETF, on the risk/return continuum. PHB offers a nice jump in yield relative to Treasuries and investment grade corporates, but without the huge dropoff in credit quality that accompanies other junk bond funds.

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Disclosure: No positions at time of writing.