High-Yield ETFs: Rotation from Junk to Quality

October 17th at 8:43am by John Spence

Investors are selling high-yield ETFs after a strong run and moving into investment-grade corporate bond funds to cut risk in their fixed-income portfolios, according to industry flow data.

In the past week, iShares iBoxx High Yield Corporate Bond (NYSEArca: HYG) and SPDR Barclays Capital High Yield Bond (NYSEArca: JNK) have both seen outflows of more than $200 million.

Meanwhile, investors have added over $300 million to iShares iBoxx Investment Grade Corporate Bond (NYSEArca: LQD), according to IndexUniverse data.

Another investment-grade ETF, Vanguard Short-Term Corporate Bond (NYSEArca: VCSH), has seen inflows of $417 million since the end of September.

The recent buying and selling patterns in corporate bond ETFs suggest investors are moving toward a risk-off attitude in fixed-income.

High-yield ETFs have been extremely popular this year with investors desperate for income in a low-rate market for bonds. HYG and JNK, the two largest ETFs in the category, are paying 30-day SEC yields of nearly 6%. They have delivered total returns of more than 15% the past year. [Is It Time to Scale Back on High-Yield ETFs?]

LQD, the investment-grade corporate bond fund, offers a 30-day SEC yield just shy of 3%. Junk bond ETFs pay higher yields to compensate investors for the risk of holding speculative-grade debt.

“We consider investing in high-yield corporate bonds to be similar to investing in the equities of companies with highly leveraged balance sheets,” says Morningstar analyst Timothy Strauts.

“With increased leverage comes the increased probability of default and bankruptcy. In the grand scheme of things, risk equals return, and the high yield of these bonds is designed to compensate investors for this risk,” he adds.

Blowing bubbles

However, some fund managers are warning the rally in junk debt has pushed yields to record lows and that the bonds may not be worth the risk, the Financial Times reports.

“Why people keep piling on junk bonds with yields at these record low levels is just beside me,” said Michael Mullaney at Fiduciary Trust, in the FT story

“There’s no doubt this is a borrowers’ market. Those investors who are forsaking credit quality in reach for yield face a material risk if we see a back-up in markets,” added Adrian Miller, global markets strategist at GMP Securities.

Companies have been taking advantage of investor demand for bonds by issuing record amounts of corporate debt this year.

“2012 continues to be the year of the corporate bond as companies remain both willing and able to take advantage of near record-low borrowing costs,” according to Benjamin Streed at Raymond James.

Bank of America Merrill Lynch notes “bubble-like” inflows to high-yield funds in 2012, which are at a record pace.

“So much money has flooded into the junk-bond market from yield-hungry investors that weaker and weaker companies are able to sell bonds,” The Wall Street Journal reports. “Credit ratings of many borrowers are lower and debt levels are higher, making defaults more likely. And with yields near record lows, they add, investors aren’t being compensated for that risk.”

Yet high-yield ETFs have remained strong despite these bubble fears, with the 50-day average providing solid support.

SPDR Barclays Capital High Yield Bond

Full disclosure: Tom Lydon’s clients own HYG, JNK and LQD.

The opinions and forecasts expressed herein are solely those of John Spence, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.

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