The fixed income market has undergone significant changes, with heightened volatility and evolving economic conditions challenging traditional investment approaches. Advisors are increasingly recognizing the limitations of passive strategies, especially in less-efficient segments of the market such as high yield.
To gain insights into potential benefits of active management in the fixed income exchange-traded fund (ETF) landscape, particularly in the high-yield sector, Wealth Advisor Managing Editor Scott Martin spoke with Mark Cernicky, a Client Portfolio Manager at Principal Asset Management. The Principal Active High Yield ETF (ticker: YLD) aims to provide a high level of current income by investing in high-yield securities, offering superior risk-adjusted returns compared to passive strategies.
According to Cernicky, passive strategies often expose investors to unnecessary risks, particularly in those segments of the market where the likelihood of downgrades and defaults is higher. High-yield bonds, known for their attractive yields, come with heightened risk, especially in the lower-rated segments such as CCC-rated instruments.
A substantial portion of these lower-rated bonds is downgraded annually, he notes, which can significantly impact returns for passive investors who hold the entire market without discrimination. Active management, on the other hand, allows portfolio managers to selectively invest in companies with improving credit fundamentals while seeking to avoid those on the brink of downgrade, potentially mitigating potential losses.
Cernicky emphasizes the importance of balancing yield with quality in the high-yield market. Although passive high-yield ETFs might offer exposure to the entire market, they also include bonds with higher risks of default. Active strategies, such as those employed in Principal’s YLD ETF, focus on identifying bonds with positive credit momentum, which could potentially enhance returns while reducing downside risk.
YLD is not a mere replica of Principal’s high-yield fund but a concentrated portfolio of the firm’s best high-yield ideas. This high-conviction approach is grounded in rigorous fundamental credit research, aiming to capture opportunities in bonds with improving credit profiles while steering clear of potential downgrades. The idiosyncratic nature of the high-yield market, where companies with vastly different risk profiles coexist, makes it ripe for active management, which seeks to exploit these disparities to enhance returns.
One of the key advantages of active management in the high-yield space is its potential to navigate the episodic waves of volatility that characterize this market. Unlike investment-grade bonds, where credit quality is relatively stable, high-yield bonds are subject to significant price movements based on changes in credit outlook. Active managers can seek to capitalize on these opportunities by adjusting their portfolios in response to market developments, thereby adding value over time.
Cernicky points out that the performance metrics of YLD underscore the benefits of active management. The ETF has demonstrated a strong upside capture ratio while maintaining a low downside capture ratio, indicating that it has been able to participate in market gains while limiting losses. This performance is partly attributed to the fund’s being constructed to avoid defaults, which is crucial in the high-yield sector where a single default can wipe out months of income.
Moreover, the relatively low fees of YLD, at 39 basis points, make it an attractive option for advisors seeking active management without the hefty price tag often associated with traditional mutual funds. This cost efficiency, combined with the potential for superior risk-adjusted returns, positions YLD as a compelling choice for advisors looking to enhance their fixed income allocations.
The current economic environment presents both challenges and opportunities for fixed income investors. With credit spreads remaining tight and the risk-return relationship becoming increasingly compressed, the question arises: does high yield still make sense? Cernicky argues that it does, particularly when approached with an active management strategy.
He notes that the credit quality of the high-yield market is currently at one of its highest levels, with many of the weaker companies having been flushed out during the COVID-19 pandemic. The companies that remain are generally stronger, with robust earnings and manageable debt levels, which supports tighter spreads. Additionally, with the likelihood of a major recession on the horizon being relatively low in his view and limited debt maturities coming due, Cernicky sees the risk of a significant spike in defaults as low.
Given these conditions, Cernicky suggests that advisors should consider high-yield bonds as a strategic, long-term investment rather than attempting to time the market. The historical performance of high-yield bonds during periods of Federal Reserve rate cuts, such as in the mid-1990s, illustrates the potential for strong returns even in a low-spread environment. This dynamic is particularly apt for active strategies that may be successful in exploiting the increased idiosyncratic risks present in today’s market.
For advisors and their clients, the current market conditions offer a compelling reason to reassess their fixed income strategies, particularly in the high-yield sector. Cernicky believes that now may be an opportune time to shift from passive high-yield ETFs or multi-sector fixed income allocations to a more targeted, active approach. The rationale is that in a market where spreads are narrow and credit risks are divergent, the potential ability to pick winners and avoid losers is more valuable than ever.
One strategy to consider is reallocating from equities into high-yield bonds. With high-yield bonds currently offering yields in the high single digits, they present an attractive alternative to equities, especially for investors looking to reduce portfolio volatility without sacrificing returns. Cernicky suggests that for advisors who have benefited from the recent strong performance in equities, rotating into high-yield bonds could be a prudent move, potentially offering competitive return with lower risk.
As the fixed income market continues to evolve, active management in the high-yield sector offers a powerful tool for advisors looking to enhance returns and manage risk. Principal’s YLD ETF exemplifies the benefits of a high-conviction, research-driven approach to high-yield investing. By selectively investing in bonds with improving credit profiles and seeking to avoid potential downgrades, YLD aims to deliver superior risk-adjusted returns while mitigating the risks inherent in the high-yield market.
For advisors and broker-dealers, the message is clear: In today’s complex fixed income landscape, relying on passive strategies may no longer be sufficient. Active management, particularly in high yield, may provide the flexibility and precision needed to navigate the challenges and seize the opportunities that lie ahead. Whether reallocating from equities or refining fixed income allocations, now may be a good time for advisors to consider incorporating active high-yield strategies into their clients’ portfolios.
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Disclosures
Carefully consider a fund’s objectives, risks, charges, and expenses. For a prospectus, or summary prospectus if available, containing this and other information, visit www.PrincipalAM.com or call sales support at 800-787-1621. Please read it carefully before investing.
ALPS Distributors, Inc. is the distributor of the Principal ETFs. ALPS Distributors, Inc. and the Principal Funds are not affiliated.
Unlike typical ETFs, there are no indices that the Principal Active High Yield ETF attempts to track or replicate. Thus, the ability of the Fund to achieve its objectives will depend on the effectiveness of the portfolio manager.
Fixed income investment options are subject to interest rate risk, and their value will decline as interest rates rise. Neither the principal bond investment options nor their yields are guaranteed by the U.S. government. Lower-rated securities are subject to additional credit and default risk. International and global investing involves greater risks such as currency fluctuations, political/social instability and differing accounting standards. Investing in derivates entails specific risks relating to liquidity, leverage and credit, which may reduce returns and/or increase volatility.
Asset allocation and diversification do not ensure a profit or protect against a loss. Investing in ETFs involves risk, including possible loss of principal. ETFs are subject to risk similar to those of stocks, including those regarding short-selling and margin account maintenance. Investor shares are bought and sold at market price (not NAV) and are not individually redeemed from the Fund. Ordinary brokerage commissions apply.
Index performance information reflects no deduction for fees, expenses, or taxes. Indices are unmanaged and individuals cannot invest directly in an index.
Principal Fixed Income is an investment team within Principal Global Investors.
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