Why HYG has underperformed JNK for the past two years

High Yield Bond Market - HYG vs JNK 2013-04-10Enlarge Graph

HYG and and JNK both track large liquid bond indices, but HYG’s tracking error cost it almost 1% over the past two years.

HYG (iShares iBoxx $ High Yid Corp Bond) and JNK (SPDR Barclays Capital High Yield Bond ETF) are the largest high yield bond ETFs currently in the market. In general, investors believe that either option will reflect the high yield market accurately enough and yield the same return, but over the past year HYG has systematically underperformed JNK. The cumulative discrepancy amounts to approximately 1% less return over the past two years.

Key differences two years ago

The key difference most investors noticed was that HYG has a 50bps expense ratio versus 40bps for JNK. Here the crowd splits: some think both ETFs are interchangeable and believe JNK is a better value due to lower fees; others think HYG charges a higher fee due to their superior performance (which did not materialize). While the HYG manager showed a more active approach to managing the fund, the tweaking of the weights versus the benchmark index actually hurt returns.

Another important difference was maturity. HYG had an overall lower maturity horizon, resulting in a lower duration (i.e. sensitivity to changes in interest rates). JNK had a longer duration, and, therefore, was more sensitive to changes in interest rates, which allowed it to benefit beyond the lower interest rates.

The third key factor was that HYG had slightly higher rated bonds, which represented a deviation from the index it was tracking, while JNK had relatively more lower rated bonds, in line with its own benchmark index.

Key driver of lower returns

Looking at the composition by rating for both HYG and JNK two years ago reveals that HYG had a much lower exposure to B rated bonds. The manager probably had a bearish view of the market at the time and decided to allocate more to higher rated bonds. This increased its tracking error and started deviating from the index, generating a return that was off from that of the index.

If the bond market prices would have decreased, HYG would have outperformed its benchmark and JNK. Instead, spreads tightened from over 6% for B-rated bonds to less than 3%, causing a significant part of the portfolio to miss out on the resulting price increase.

There were also some mismatches in terms of maturity, but these had a negligible contribution to the lower return.

Current comparison and investor options

Looking at the composition of both HYG and JNK reveals that now they are much more similar to each other. HYG continues to have slightly lower duration, but the difference in share of single B rated bonds is now half, hence both funds should perform more closely in the future.

If interest rates do go up, then HYG would be a better bet since the prices would not decrease as much, though if your investment thesis is that interest rates are increasing, then SJNK would be a better option. SJNK has a much shorter duration as it invests only in bonds with maturities below five years.

Another option to protect against rising interest rates would be to switch to leverage loans (e.g. BKLN, SNLN), which pay a floating interest rate and, therefore, have negligible duration and null sensitivity to interest rates.