Junk Bond ETFs Would Get Hit by Rising Interest Rates

February 27th at 9:34am by John Spence

High-yield bond ETFs were fashionable in 2012 although so far this year the funds have seen outflows as Treasury yields tick higher.

Banks continue to underwrite massive amounts of high-yield debt but there are fears investors could get burned if the Federal Reserve scales back on its purchases of Treasury bonds and interest rates rise.

“The risks to investors are less about the bonds’ creditworthiness and more about benchmark government borrowing rates that eventually must rise after falling to a three-decade low,” Bloomberg News reports Wednesday.

“The rate environment is probably more of a risk today,” said Marc Warm, head of U.S. high-yield capital markets at Credit Suisse Group, in the article.

Junk bond ETFs have seen their assets explode to $30 billion in less than six years. Last year investors funneled $33 billion into mutual funds and ETFs that invest in high-yield debt. The iShares iBoxx High Yield Corporate Bond (NYSEArca: HYG) and SPDR Barclays Capital High Yield Bond (NYSEArca: JNK) are the largest junk debt ETFs.

The rally in junk bonds has pushed the average yield on speculative grade bonds below 6% for the first time ever. However, high-yield spreads relative to Treasuries aren’t flashing bubble-like conditions at the moment.

Instead, the worry is that rising Treasury yields would hit bonds across the board.

“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 recent memo to investors.

“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.” [High-Yield Bond ETFs Can’t Shake Bubble Talk]

Michael Holland, chairman of Holland & Co., told Bloomberg that bond prices are acting like dot-com stocks during the Internet craze. “I’ve been in the business for 40 years, and the reality is that we’ve never had a situation like this because this is totally manufactured by the Fed,” he said.

“The interest-rate risk is just a law of nature,” said Craig Packer, head of Americas leveraged finance for Goldman Sachs, referring to junk bonds.

“I don’t know if it will be this year, but five years from now we’re going to look back and realize that investors were taking on real interest-rate risk when they were buying any of these products and that risk came to fruition,” Packer said in the Bloomberg story. “I feel pretty comfortable predicting that. It’s not the 2006-2007 credit risk. It’s the 2013 interest-rate risk.”

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

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