Benchmarking with Euro Bond ETF

Bond ETF is now an important investment vehicle for US based high yield investors with the top 5 HY Bond ETF accounting for a total market cap of exceeding $40bn at the time of writing (24/6/14). While it is still just a small fraction of the $1.5tn US high yield market, the leading ETF iShares iBoxx $HY Corp Bond ETF (HYG – $13.5bn market cap) and SPDR Barclays HY Bond ETF (JNK– $9.8bn market cap) are closely following by many investors as the passive investment style of the ETFs makes them ideal benchmark (either when comparing with other funds or other asset classes). Moving across the Atlantic, HY bond ETF also enjoys phenomenal growth. The market cap of the biggest iShares iBoxx Euro HY Corp Bond ETF (IHYG) has grown more than 10-fold since Dec 2010 and reaches a market cap of EUR3.2bn.

While both HYG and IHYG are tracking iBoxx based of HY bond indices, there are reasons related to the market structure and the index construction rules that make IHYG different from both its HYG sibling and the general European HY market. It would thus be useful to have better understanding upon this index before making direct comparison between IHYG and other benchmark indices.

Comparison between IHYG and HYG

The rating distribution profile (Figure 1) suggests that the weighted average rating of IHYG is slightly better than HYG. In the BB bucket, IHYG is titled towards BB+ whereas that of HYG is more concentrated on BB-. The B and CCC buckets are largely similar. 26% of the bonds in IHYG are fallen angels. In comparison, only 6% of HYG bonds were issued as investment grade and downgraded after then.

Figure 1: Rating Profile
Figure 1: Rating Profile

In terms of bond maturity (Figure 2), the average maturity of IHYG (4.1Y) is much shorter than that of HYG (6.6Y). IHYG has almost 20% higher weights in each of the 0-2 and 2-5 year buckets. Despite IHYG has a lower percentage of callable bonds (36% IHYG vs 63% in HYG), its significantly shorter average maturity dominates the duration calculation. The effective duration of IHYG is 2.47 versus 3.98 in the case of HYG. IHYG currently behaves more similar to a shorter maturity index than one with a nominal maturity of 5-7Y.

Figure 2: Maturity Profile
Figure 2: Maturity Profile

The high proportion of IHYG bonds in 0-2 year bucket is intriguing. New issuers are unlikely to issue bonds with such short maturity. For seasoned bonds, the companies would have refinanced them under this low yield environment if the outstanding bonds are callable. When examine the bonds in the 0-2 year bucket, it turns out many of them are fallen angels (utilities, autos, and the industrial group such as Arcelor Mittal, Heidelberg and Lafarge) entered the HY index at the peak of European sovereign debt crisis. Since these formerly investment grade bonds are largely bullet (ie non-callable), they are kind of trapped in the index either until they expire or being upgraded back to investment grade.

The sector distribution is shown in Figure 3. IHYG has higher exposure in financials whereas HYG is more concentrated on energy (in particular natural gas drilling and distribution related) and consumer non-cyclical (mainly health care providers). While the financial bucket of HYG is largely comprised of specialty financing providers – SLM, Ally, CIT etc, lower Tier 2 and senior unsecured bonds of weaker banks of weaker European banks are the main constituent in the case of IHYG. Notably, Tier 1 bonds are missing from IHYG altogether.

Figure 3: Sector distribution
Figure 3: Sector distribution

Tier 1 bonds, either legacy Tier 1 or the recent Additional Tier 1 (AT1), are supposed to be perpetual. While they are mostly rated below investment grade and should fit the rating criterion, the maxium maturity constraint of 10.5-year has excluded them from IHYG. Tier 1 bond is an important component in the European HY market. Take the Additional Tier 1 (AT1) bonds as an example. The issuance so far has reached EUR40bn (close to 10% already of the EUR 500bn European HY market size) to fulfil the Basel III and CRD IV requirement. More issuances are in the pipeline. Excluding these bonds from IHYG altogether could lead to significant discrepancy in performance between it and the general European HY market.

IHYG as a benchmark
Another common practice is to benchmark HY bond index against CDS index (e.g. IHYG against Itraxx Crossover 5-year index) as an indication of the cash bond – CDS basis. We should bear in mind IHYG currently a fairly short weighted maturity and duration when compared with the nominal Crossover 5-year index. Many analytics will be distorted. If our intention is to assess the relative value between markets (e.g. CDS vs cash bond, or Europe vs US cash bond), we would get much more reliable results by imposing constraints upon both rating and maturity (e.g. compare Euro 5-7Y BB bond against the USD equivalent).