The largest high-yield bond ETFs are currently yielding less than 5% after a strong run-up in price but S&P says the fixed-income sector still offers opportunities if investors are mindful of the risks.
Junk debt ETFs such as iShares iBoxx High Yield Corporate Bond (NYSEArca: HYG) and SPDR Barclays High Yield Bond (NYSEArca: JNK) logged net inflows of nearly $10 billion last year although purchases have slowed in 2013.
“We think the strong demand for these fixed income offerings is tied to the low interest-rate environment and corporations generating record profits in the first quarter of 2013,” said Todd Rosenbluth, S&P Capital IQ director of ETF research, in a note this week.
Companies have tapped the demand for yield with new corporate speculative-grade bond issuance hitting a record $98 billion in the first four months of the year.
Investor hunger for yield has also narrowed the yield spread between Treasuries and junk debt in 2013.
The speculative-grade spread has declined approximately 20% from 554 basis points at the beginning of 2013, according to S&P. Relative to the last five years, the speculative-grade spread is 39% below the 745 basis points average.
Rosenbluth said the tight spread is the result of historic low yields in the 10-year Treasury and investors growing more optimistic about corporate earnings.
“Meanwhile, Standard & Poor’s Ratings Services expects that the U.S. corporate trailing 12-month speculative-grade default rate will increase to 3.3% by March 2014, from the 2.5% achieved in the 12 months ended March 2013,” he added. “The baseline forecast is partially based on assumptions that the U.S. economy will grow by 2.7% in 2013 and the unemployment will decline to less than 7% by the first quarter of 2014. While a higher default rate is a modest concern, it should be noted that the long-term average default rate in the 1981-2012 period was 4.5%.”
And although junk debt ETF yields are appealing relative to Treasuries, there are elevated risks to be aware of, S&P cautioned. The funds have heavy concentrations in bonds rated BB or lower, for example.
JNK and HYG have durations of roughly five years, so they don’t take on much interest rate risk.
For those seeking high-yield ETFs with shorter durations, PIMCO 0-5 Year High Yield Corporate Bond Index (NYSEArca: HYS) and SPDR Barclays Short-Term High-Yield Bond ETF (NYSEArca: SJNK) can be considered. [High-Yield Bond ETFs for Rising Rates]
“Despite credit spreads, we think ETF investors should still find favorable opportunities in the high yield space,” Rosenbluth said.
Full disclosure: Tom Lydon’s clients own JNK and HYG.