Although U.S. money and bond market ETF yields have returned to what is considered to be historically “normal” levels, investors are still looking to utilize a “plus” component within their fixed income ETF portfolios. Oftentimes, leveraged loans, or bank loan ETFs, are deployed to achieve this objective of generating more income outside of one’s core holdings. However, WisdomTree offers a quality-screened solution in this space for investors to consider.

By definition, bank/senior loan ETFs are typically considered to be in the high yield fixed income bucket and consist of a floating-rate structure—in other words, a high yield solution that mitigates interest rate risk. Enter the WisdomTree Interest Rate Hedged High Yield Bond Fund (HYZD). This potential substitute for bank loan ETFs offers a very similar profile for investors, i.e., a high yield “plus” solution with limited—or, in HYZD's case, no—duration.

However, this is where the similarities end. HYZD is designed to provide a quality solution outside of the investment-grade space, where fears of default can be a major concern. Indeed, in the investment-grade sphere, downgrades are the main concern, while in the high-yield world, defaults are the primary risk. HYZD uses a filter where free cash flow (FCF) serves as the credit risk mitigator while also employing equity momentum factors. The remaining bonds are then given a liquidity score and tilted toward issues that exhibit favorable income characteristics.

Additionally, HYZD uses a professional approach that combines these long positions in high-yield corporate bonds with short positions in Treasury securities to target zero duration on a monthly basis. This helps investors reduce their overall duration at a minimal cost to yield.

The results essentially speak for themselves. As shown below, HYZD has been able to considerably lessen the risk of defaults compared to the high yield market capitalization measure over roughly the past ten years (cumulative high yield defaults of nearly 15% for the broader market versus only 2% for HYZD).

Cumulative High-Yield Defaults

Another key difference is that bank loan ETFs tend to have less diversification, with holdings concentrated in just a few sectors, while HYZD uses the broader high yield market and spreads exposure across different sectors. In addition, last twelve-month free cash flow data show this key metric is trending lower and has moved into negative territory for bank loan ETFs. Remember, free cash flow is the primary quality-screened factor for HYZD.

Conclusion

For investors looking to add income potential to their core bond ETF portfolio, HYZD provides a quality-screened substitution to the very large bank loan ETF space.