How To Dodge Energy Defaults With a High-Yield Bond ETF

Last year, it was CCC-rated debt (and lower) and low oil prices weighing on junk bonds and the corresponding exchange traded funds. More than 40 energy producers have filed for bankruptcy protection since 2014 and earlier this year, Fitch Ratings estimated $40 billion in energy sector debt defaults. 

As of mid-May there was already $26 billion in energy defaults on a year-to-date basis, well above the $17.5 billion seen last year. 

Indeed, it is still a good idea for investors hunting for yield with junk bond ETFs to steer clear of energy credits. The newly minted WisdomTree Fundamental U.S. High Yield Corporate Bond Fund WFHY is an ETF that helps with that objective.

The WisdomTree Fundamental U.S. High Yield Corporate Bond Fund follows the WisdomTree Fundamental U.S. High Yield Corporate Bond Index, which only includes high-yield corporate debt “with at least $500 million in par amount outstanding and a remaining maturity of at least one year,” according to WisdomTree.

At the end of April, the WisdomTree Fundamental U.S. High Yield Corporate Bond Index devoted just two percent of its weight to high-yield energy debt, well below the double-digit energy weights found in traditional high-yield corporate bond ETFs. WFHY skirts the riskiest energy credits because the ETF's underlying index emphasizes free cash flow.

“Over the course of our research on the high-yield (HY) bond market, we found that free cash flow (CFC) was among the most significant predictors of future credit ratings downgrades or companies falling into financial distress. As a result, our Indexes include only bonds from companies with positive FCF over the previous five years (on average). During the course of our conversations about the strategies, one of the most frequent questions we’ve received is how our methodology has reacted to the swoon in energy credit fundamentals,” said WisdomTree in a note out Monday.

Less than 12 percent of WFHY's index is allocated to CCC-rated debt as bonds rated BB or B combine for 87.5 percent of the benchmark's weight. Home to 375 bonds, the WisdomTree Fundamental U.S. High Yield Corporate Bond Index has an effective duration of 4.4 years.

“While a quality approach may not outperform all the time, we believe the current market environment in energy credit continues to warrant caution. As a result, we do not believe market cap-based strategies with significant exposures to high-yield energy provide enough compensation, given the risks currently facing the market,” adds WisdomTree.