Investors Pile Into Corporate Bond ETFs as Credit Quality Declines

December 26th at 1:44pm by John Spence

The three largest ETFs that invest in corporate debt have gathered nearly $15 billion this year even though ratings agencies are downgrading the bonds at the fastest rate since the financial crisis.

Among the 10 best-selling ETFs in 2012, two funds on the list track corporate bonds: iShares iBoxx Investment Grade Corporate Bond (NYSEArca: LQD) and iShares iBoxx High Yield Corporate Bond (NYSEArca: HYG).

LQD has seen year-to-date net inflows of $6.9 billion while HYG has brought in $4.5 billion, according to IndexUniverse data. Meanwhile, SPDR Barclays High Yield Bond (NYSEArca: JNK) has hauled in $3.1 billion. [Investment-Grade Bonds May Cool After ETF Hauls in $7 Billion]

Corporate defaults rose this year from 2011 while a slowing global economy and record borrowing are eroding credit quality, Bloomberg News reports. Speculative-grade or “junk” debt is seeing the most downgrade pressure.

Companies around the world have issued nearly $4 trillion of debt this year to lock in yields that are hovering a bit above 3%, according to the article. The demand for corporate debt has pushed bond prices higher and yields to extremely low levels.

In high-yield bonds, trading in ETFs following the sector is rising at a faster rate than transactions in the underlying junk debt.

HYG and JNK, the junk ETFs, are paying 30-day SEC yields of more than 5% while yields on 10-year Treasury notes are hovering around 1.8%.

According to fixed-income portfolio manager David Schawel, the spread between junk-bond yields and the S&P 500 earnings yield recently turned negative for the first time ever, “showing just how much the yields on high-risk bonds have come down as central banks keep benchmark borrowing rates depressed and investors search further out on the risk spectrum for yield.”

“Even as credit quality deteriorated, Fed efforts to push investors into riskier assets drove unprecedented amounts of cash into the corporate debt market, fueling the biggest gains since 2009,” Bloomberg reports.

However, after such a strong run, some traders are using high-yield bond ETF options to speculate on a pullback or hedge existing positions. [Junk Bond ETF Yielding Over 6% Sees Record Bearish Bets]

“If you look at some of the spreads where these corporates are trading, you start to wonder how much more of a rally can you get?” Kenneth Naehu, portfolio manager at Bel Air Investment Advisors, told Bloomberg. “That doesn’t mean it’s impossible, you’re just up against levels that will be difficult to rally from.”

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.

Tickers