High-yield corporate bond ETFs fell suddenly in January, hinting that U.S. equities were due for a pullback following an early-year rally. Junk debt ETFs have recouped some of last month’s losses but still face speculation the fixed-income sector is overvalued after posting robust performance.
The rally in junk bonds has pushed the average yield on speculative grade bonds below 6% for the first time ever. [Are High-Yield Bond ETFs Overvalued After Big Run?]
“These days the question is primarily whether high yield bonds are in a bubble and poised to collapse, given last year’s strong performance and today’s historically low yields. We don’t think high yield bonds are any more vulnerable to rising rates than other fixed income instruments. We don’t downplay the risk in the market nowadays and the fact that bond prices are quite high,” wrote Howard Marks and Sheldon Stone at Oaktree Capital Management in a memo to investors last week.
“However, the situation isn’t unique to high yield bonds; rather, it is true of virtually all bonds and reflects the concerted effort on the part of central banks around the world to hold down interest rates,” they noted. “Yields are at historic lows and prices are unusually high all across the fixed income spectrum.”
Other analysts point out that high-yield spreads relative to Treasuries aren’t flashing bubble-like conditions at the moment. Junk bond credit spreads are not anywhere near all-time historical lows. Also, corporate default rates are low and the fact remains that investors don’t have many options for income with 10-year Treasury yields hovering around 2%. [High-Yield Bond ETF Pullback a Warning Signal for Equity Bulls?]
The iShares iBoxx High Yield Corporate Bond (NYSEArca: HYG) and SPDR Barclays Capital High Yield Bond (NYSEArca: JNK) are the largest junk debt ETFs. They are paying 30-day SEC yields of more than 5%. Both ETFs posted total returns of more than 11% in 2012.
“Of course it’s most unlikely that high yield bonds will deliver returns even close to 2012’s performance. On the other hand, they don’t have to equal last year’s return to warrant holding today. While yields are near all-time lows, yield spreads tell a very different story,” Oaktree said.
“So we don’t think high yield bonds are overpriced in relative terms,” it added. “In fact, we feel the odds favor their delivering relative performance that is superior to Treasurys and high grade corporates over multi-year holding periods ahead.”
Full disclosure: Tom Lydon’s clients own HYG and JNK.