Cracking high yield beta

Can a fund replicate the US high yield bond index, outperform an equivalent ETF and have better liquidity? Mellon's 1* Claire Corry argues it can.

Efficient beta and dynamic allocation strategies could be the name of the game for investors seeking nuanced market exposure, says Claire Corry, of Mellon's beta team.

Corry highlights Mellon's US high yield beta strategy as one that sets out to solve a problem: how do you replicate or improve on the performance of the US high yield bond index but with lower transaction costs and improved liquidity?

This is an important question, says Corry, since many active managers in this space have tended to underperform their benchmarks. Over the past 10 years, she says, less than 3% of high yield mutual funds have outperformed on this measure – indeed, the index itself has been top quartile versus institutional managers.2

There are a range of reasons for this underperformance, says Corry, not least shrinking broker inventory levels since the global financial crisis. "A smaller universe equates to a real lack of liquidity for lower quality issuers and smaller or aged issuers, which in turn means greater trading frictions and consequently higher trading costs," she says. "For active managers these hurdles can be difficult to overcome and it does help explain why performance suffers. Meanwhile, any alpha generated by active managers will tend to be eaten up by fees."

To address these problems, the US high yield beta strategy adopts a hybrid approach, with elements of both passive and active investment. The starting point is to "crack" the best performing US high yield ETF to create an equivalent basket of bonds. At this point, Mellon's bespoke credit model is layered in, effectively minimising the impact of riskier or lower liquidity instruments. The next step is to build the allocation back up using Mellon's proprietary risk system and source bonds directly through the cash bond market. Finally, a layer of exposure to a high yield credit default index is added as a market completion tool.

Says Corry: "Our credit model and the flexible implementation tools are our 'special sauce'. They allow us to create a bespoke allocation which effectively mirrors the beta of the high yield market, with superior performance, improved liquidity and lower fees than you'd expect from the standard approach to investing in US high yield bonds."

To date, the strategy has achieved this goal, outperforming its comparative index3, gross of fees, on a one-year, three-year, five-year and since-inception basis.4 This is despite the comparative benchmark already being a top-quartile performer in its own right. Crucially, the strategy has achieved this outperformance with beta of 1.0 versus the benchmark and with similar credit, duration and maturity characteristics.5

High yield beta composite performanc (calendar year returns, %)
Source: Mellon and Barclays POINT/Global Family of Indices as at 31 December 2018. Performance calculated as total return, income reinvested, gross of fees, in US$. Fees and charges apply and can have a material effect on the performance of your investment.
Source: Mellon and Barclays POINT/Global Family of Indices as at 31 December 2018. Performance calculated as total return, income reinvested, gross of fees, in US$. Fees and charges apply and can have a material effect on the performance of your investment.

1 Investment Managers are appointed by BNY Mellon Investment Management EMEA Limited (BNYMIM EMEA) or affiliated fund operating companies to undertake portfolio management activities in relation to contracts for products and services entered into by clients with BNYMIM EMEA or the BNY Mellon funds.

2 Source: S&P Dow Jones Indices LLC, CRSP. SPIVA U.S. Scorecard: Mid-Year 2018. Data as of 30 June 2018. Outperformance is based upon equal weighted fund counts.

3 The Bloomberg Barclays US Corporate High Yield Index.

4 30 September 2012.

5 Source: Mellon and Barclays POINT/Global Family of Indices as of 31 December 2018. Based on a representative portfolio that adheres to the same investment approach as Mellon’s high yield beta strategy.

* Mellon was formed on 31 January 2018, through the merger of The Boston Company and Standish into Mellon Capital. Effective 2 January 2019, the combined firm was renamed Mellon Investments Corporation.

Past performance is not a guide to future performance.

The value of investments can fall. Investors may not get back the amount invested.

INV016018 Exp 29 June 2019. Published as at 29 March 2019.

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Mellon was formed on 31 January 2018, through the merger of The Boston Company and Standish into Mellon Capital. Effective 2 January 2019, the combined firm was renamed Mellon Investments Corporation.