Fallen angels: The new high-yield bonds

The effect on indexes and index funds

A downgrade to high-yield status leads affected securities to be excluded from an investment-grade index, and it requires index funds to divest them. But such downgrades rarely come as a surprise, and Vanguard index funds are well-positioned to take action on them.

“We do have to be sellers of those bonds,” said Josh Barrickman, principal and co-head of Vanguard bond indexing for the Americas. “But we have quite a bit of leeway about how and when we exit those positions.”

Vanguard’s deep and experienced credit research team works to identify companies whose fundamentals may be deteriorating. “If there’s a name that we have particular concern about a downgrade,” Mr. Barrickman said, “we can start positioning in advance, underweighting the name or getting to a place where we’re holding the bonds we think will be most desirable to high-yield investors, or getting out of less-liquid bonds and into more-liquid bonds before the downgrade happens.”

Such downgrades clearly aren’t positive events for index funds. “It does hurt performance generally as these go from Price A to Price B as they matriculate between investment-grade and high-yield indexes,” Mr. Barrickman said. As an index fund provider, Vanguard is “concerned about tracking, but we’re also concerned about getting the best possible price as we sell these securities. It’s a bit of a balancing act, perhaps half science and half art.”

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