High-yield bond exchange traded funds have been among the better performing fixed-income investments in recent weeks as the asset category steadily strengthened while Treasuries sold off, but junk bonds are not without their risks ahead.
“We can’t help but feel that 2017 is likely to be a finely balanced year, with as many reasons to be optimistic as cautious,” Rob Bush, ETF Strategist for Deutsche Asset Management, said in a note.
The iShares iBoxx $ High Yield Corporate Bond ETF (NYSEArca: HYG) and the SPDR Barclays High Yield Bond ETF (NYSEArca: JNK), the two largest high-yield corporate bond exchange traded funds by assets. rose 1.9% and 2.3% over the past month, respectively. The recently launched Deutsche X-trackers USD High Yield Corporate Bond ETF (NYSEArca: HYLB) has also quickly attracted investors’ attention, accumulating $136.2 million in assets under management since its December 7 launch.
On the positive side, a strengthening economy will help diminish credit risk. Deutsche’s CIO team is forecasting U.S. growth of 2.2% next year, or a little more than the 2.1% five-year average. Due to junk bond’s more “equity-like” nature compared to Treasuries or investment-grade debt, high-yield bonds could strengthen on the higher growth environment in the U.S., especially with rebounding oil prices that would further diminish credit risk for energy-related speculative-grade debt, the largest sector that makes up about 15% of high-yield market.
While interest rates are rising, rates are still hovering near historical lows, which will help make it easier for companies to repay debt or reduce default risks. More quick-witted corporate treasurers have already locked into low, long-term loans, further mitigating default risks.
Moreover, President-elect Donald Trump may enact looser regulatory restrictions and corporate tax cuts that could allow many companies to repatriate cash and enhance corporate earnings. Bush argued this would mean more cash on balance sheets and less concern over meeting interest payments.
Trump’s protectionist promises could also support domestic companies or support high-yield firms with relatively larger exposure to the U.S. market.
On the other hand, interest rate risk and credit spreads may keep pressure on the speculative-grade bond market. Bush, though, argued that since yields on benchmark 10-year notes are already tracking above the forecasted 2.50% average, the markets have already priced in the worst case scenario.
“That might mean the harm higher interest rates can have on any fixed income portfolio has already been done,” Bush said.
Deutsche strategists also warned that credit spreads in high-yield debt could widen a little in next year, which would detract from higher coupons, mainly from the energy segment. Some leveraged U.S. oil producers issued debt when oil prices were much higher, and any potential decline in crude prices could caused magnified risks in this segment of the junk bond market, similar to what we saw at the end of 2015. Bush pointed out that the correlation between Bloomberg Barclays Corporate High Yield index and spot price crude oil was 0.53 in the first three months of 2015, compared to a much lower 0.24 for the 10-year correlation between the two.
For more information on the speculative-grade debt market, visit our junk bonds category.