Riskier speculative-grade debt and bond-related exchange traded funds have retreated over the past year and are trading at relatively attractive valuations. However, rising corporate default rates could bar the asset category from a full recovery.
Junk bonds have rebounded alongside the equities market from the February lows. Year-to-date, the SPDR Barclays High Yield Bond ETF (NYSEArca: JNK) rose 1.7% and iShares iBoxx $ High Yield Corporate Bond ETF (NYSEArca: HYG) gained 2.2%.
The speculative-grade debt market, though, may have a hard time regaining lost ground ahead as credit risk comes back to the forefront. According to ratings agency Standard & Poor’s, more companies have defaulted globally so far this year than during the start of any year since 2009, reports Josie Cox for the Wall Street Journal.
The S&P’s findings mirror Moody’s expectations that corporate defaults could hit its highest rate since the financial crisis, led by the energy and mining sectors.
“In the past six years, the global economy has enjoyed a benign default environment as accommodative monetary policies have fueled the corporate debt market with abundant liquidity, allowing many low-rated issuers to refinance when needed,” according to a Moody’s report. “The party is likely coming to an end soon as the global default rate is expected to approach the historical average mark by the end of 2016.”
Year-to-date, there were 40 defaults, with four companies defaulting this week, including three in the oil and gas sector. Oil, gas and mining companies make up the majority of defaults this year as commodity prices weakened over the past year. Diane Vazza, S&P’s head of fixed income research, found that 14 of the 40 defaults have come out of the oil and gas sector this year and eight from the metals, mining and steel sector.
Alternatively, given the heightened credit risk, fixed-income investors may consider junk bond funds that lean toward higher quality debt. For instance, the Market Vectors Fallen Angel High Yield Bond ETF (NYSEArca: ANGL) tracks so-called fallen angel, speculative-grade debt, or those bonds that were born with investment-grade ratings but were later downgraded to junk territory. Fallen angel issuers tend to be larger and more established than many other junk bond issuers. Furthermore, since these fallen angels were formerly on the cusp of investment-grade status, this group of junk bonds typically has a higher average credit quality than many other speculative-grade debt-related funds. ANGL’s credit qualities include BBB 6.6%, BB 73.9%, B 9.8%, CCC 3.5% and CC 0.1%.
The PowerShares Fundamental High Yield Corporate Bond ETF (NYSEArca: PHB), which tracks the RAFI Bonds US High Yield 1-10 Index, leans toward slightly higher quality corporate debt securities than its major competitors. The underlying Research Affiliates index implements a fundamental or smart-beta indexing methodology that focuses on four factors, including gross sales, gross dividends, cash flow and book value of assets for each issuer. The end result is an index of company debt with higher credit ratings, including some low-investment-grade BBB 18%, along with speculative-grade BB 57% and B 25%.
The slightly higher credit quality may also explain why ANGL and PHB are outperforming HYG and JNK. Year-to-date, PHB advanced 3.3% and ANGL increased 6.9%.