While fixed-income assets are subject to rate risks, junk bond exchange traded fund investors also have to monitor credit risks, but now default rates on speculative grade debt have dropped to a six-year low.
According to Moody’s Investor Service, default rate among junk-bond U.S. companies fell to 1.7% at the end of the first quarter, the lowest since February 2008, from 2.2% in the fourth quarter of 2013, reports Michael Aneiro for Barron’s.
The current default rate is well below the historical default rate for high-yield bonds, which averaged 4.5% since 1993, according to Moody’s data. Moody’s, though, warns that default rates could rise to 2.4% by the end of the year and 2.7% in 2015.
The capital markets “continue to be open for low-rated companies, supporting a low default rate,” Moody’s said.
As a result of the Fed’s record low rate policies, most junk-rated companies have been able to refinance old debt, extend maturities and lower borrowing costs.
Nevertheless, speculative grade, junk bonds are one of the riskier assets in the fixed-income space.
“Investors should bear in mind that high-yield bonds are one of the most volatile sectors of the fixed-income market,” according to Morningstar analyst John Gabriel. “In many cases, issuers are classified as high-yield due to relatively high levels of financial leverage. This means that the risk of default is elevated, as (even for high-quality businesses) financial leverage decreases a firm’s margin of safety.”
The ultra-low default rates have helped attract greater investment interest in the junk bond market that yields an average 5.2%. The benchmark Bank of America Merrill Lynch Index has gained 3.3% so far this year. [A Revival in Corporate Bonds, ETFs]
The iShares iBoxx $ High Yield Corporate Bond ETF (NYSEArca: HYG) and SPDR Barclays High Yield Bond ETF (NYSEArca: JNK), the two largest junk-bond related ETFs, have gained 2.9% and 3.2% year-to-date, respectively.
HYG has a 4.48% 30-day SEC yield. The ETF has a small 6.6% allocation to BBB-rated, low investment grade quality bonds. The rest of its portfolio is allocated to speculative grade BB 45.9%, B 26.5%, CCC 10.7%, not rated 3.1% and other securities 6.9%.
JNK has a 4.81% 30-day SEC yield. The fund includes a lower 0.9% weight toward investment grade BBB-rated bonds, along with BB 38.8%, B 41.3% and CCC or lower 19.0%.
For more information on speculative grade debt, visit our junk bonds category.
Max Chen contributed to this article.
Full disclosure: Tom Lydon’s clients own shares of HYG and JNK.