Investors have pumped over $9 billion into junk bond ETFs so far this year as they take on more risk in their endless search for yield. However, some analysts are worried high-yield ETFs are helping to foster a bubble in speculative-grade corporate debt with insatiable demand pushing yields to record lows.
“As investors continue their quest for yield amidst low interest rates, high-yield ETFs have been playing an increasingly important role in the market for speculative-grade bonds,” according to Standard & Poor’s.
“The demand for fixed-income ETFs has been brisk in recent years,” said Diane Vazza, head of Standard & Poor’s Global Fixed Income Research.
For example, junk bond ETFs gathered $1.6 billion of inflows in September alone, or 4.5% of new speculative-grade bond issuance during the month.
“However, the ease with which investors can enter and exit ETF investments creates new and risky dynamics in the speculative-grade market with the potential flow of ‘hot money,'” Vazza said.
Junk bonds pay higher yields than investment-grade corporates to compensate investors for the risks of owning lower-quality debt. Inflows to high-yield bond funds have climbed to a record this year. [Is It Time to Scale Back on High-Yield ETFs?]
Even though high-yield ETFs have been popular in 2012, the funds have seen outflows in recent weeks amid concerns over the U.S. fiscal cliff and Europe’s debt crisis.
For example, since the end of September, iShares iBoxx High Yield Corporate Bond (NYSEArca: HYG) has experienced withdrawals of $433 million, according to IndexUniverse data. Meanwhile, iShares iBoxx Investment Grade Corporate Bond (NYSEArca: LQD) has gathered over $1 billion. [High-Yield ETFs: Rotation from Junk to Quality]
“Speculative-grade companies have a higher default risk than investment-grade companies. Therefore, when the credit cycle turns against investors, losses from defaults can quickly outstrip the additional interest payments that high-yield investors receive,” according to S&P. “Since we are entering the stage of declining credit quality in the current credit cycle, the credit quality of an issuer or a portfolio has become paramount.”
Junk bonds have seen yields steadily decline in absolute terms and relative to Treasuries, “creating a financing bonanza for companies whose credit rating is below investment grade and for the banks underwriting their debt issuance,” Thomson Reuters reports.
“But questions about corporate earnings may provoke questions about whether investors’ hunger for interest income has driven valuations too high, and yields too low,” it adds. “Yields on so-called junk bonds have hit almost surreally low levels over the course of 2012, due to a combination of the intense hunger for income on the part of investors and the equally astonishing level of yields on Treasury securities.”
Other junk bond ETFs include PIMCO 0-5 Year High Yield Corporate Bond Index Fund (NYSEArca: HYS), SPDR Barclays Capital High Yield Bond (NYSEArca: JNK) and PowerShares High Yield Corporate Bond Portfolio (NYSEArca: PHB).
The junk bond ETFs are paying yields between 4% and 6%.
Full disclosure: Tom Lydon’s clients own HYG and JNK.