Could High-Yield ETFs Be The New CDOs?

Passive management strategies in high yield promote lax lending standards and sketchy supply, much as they did during the precrisis CDO boom. For investors, this could mean lower credit quality and a higher probability of default.

There’s a place for both passive and active strategies in a well-diversified portfolio. But many investors are using the former as a substitute for the latter. We think that’s a mistake—especially in high yield.

Investors find high yield appealing because it’s one of the few remaining fixed-income sectors that still offers attractive yields in today’s low-interest-rate environment. But a growing number are choosing to access the market with exchange-traded funds (ETFs), which passively track an index.

That can be chancy. The high-yield market is a complex one. Issuer credit quality varies widely, and so do the risks. Active managers can draw on detailed credit analysis to navigate the market and decide which companies to lend to. Passive ETF investors lend indiscriminately to every company that borrows enough to make it into the index.

This can create poor incentives and bad supply. If companies know they can borrow cheaply from passive lenders, some may conclude there’s no reason to run a tight financial ship by keeping leverage ratios under control. That could result in higher default rates and undermine the quality of the broader market.

Learning Lessons from CDOs

We don’t have to go too far back in time to see how this sort of thing can turn out. Today, we all know that mortgage lenders prolonged the US housing boom in the 2000s by making ill-advised loans to underqualified borrowers for houses they couldn’t afford. Lenders were able to make all those loans for one simple reason: they knew they could offload the risk onto someone else.

That someone else turned out to be all the investors who wanted exposure to mortgages. They got that exposure by piling into financial vehicles called collateralized debt obligations, or CDOs, which bundled different kinds of mortgage debt into individual securities that were then sold to investors.

All that investor demand allowed lenders to make riskier and riskier loans. Eventually, the music stopped—and investors who had blindly bought these CDOs were left holding a pile of bad loans.