ETF Trends
ETF Trends

Junk bond ETFs have enjoyed four solid years of returns while investors’ hunger for income-producing assets has pushed the sector’s yields down near record-low levels. As 2013 gets underway, some investors are again wondering if high-yield corporate debt is overvalued after such a strong run.

The only problem is that investors don’t have too many other options when it comes to finding yield with the Federal Reserve committed to keeping rates low for a couple more years.

“With record fund inflows in 2012, investors clearly have an appetite for high-yield bond funds,” says Morningstar analyst Timothy Strauts. “The strong investor demand lowered credit spreads, and the high-yield category returned over 14% last year. While yields have been falling, high yield is the only bond category with a 12-month yield still above 5%.”

SPDR Barclays High Yield Bond (NYSEArca: JNK) and iShares iBoxx High Yield Corporate Bond (NYSEArca: HYG) are the largest ETFs that invest in high-yield corporate debt. The funds were big sellers in 2012 and allow investors to buy a basket of high-yield bonds with one trade and low fees.

The sector’s rally has pushed the average yield on speculative grade bonds below 6% for the first time ever. [Junk ETFs Highest Since 2008]

Fed-fueled bubble?

“One of the aims of the Federal Reserve interest rate policy is to increase risk-taking across the capital markets. High yield is one of the main beneficiaries of the Fed’s current policy. With yields of investment-grade securities below 3%, investors have been forced to look elsewhere for income. Many institutional investors that in the past only chose investment-grade bonds have been buying high yield to meet their return targets,” says Strauts at Morningstar.

“This new demand has pushed yields down and given corporations the ability to refinance a lot of debt in 2012. It was a record year with over $300 billion in new bond issuance. The ability for even very low-rated, highly leveraged companies to get financing has helped many firms stay afloat when they would otherwise have defaulted in a normal year,” he wrote in a recent commentary. “The high demand for these speculative issues has caused some investors to discard fundamentals in favor of searching for the highest yield without regard for quality. This strategy has worked so far, but at some point demand will soften, poor business fundamentals will catch up with firms, or the Fed will change its policy.”

Despite worries that high-yield bonds are in a bubble, corporate defaults are below the historical average.

Although high-yield bonds are often considered high-risk and speculative, the asset class has outperformed the S&P 500 the past five years with less volatility, says Peritus Asset Management, the subadvisor for Peritus High Yield ETF (NYSEArca: HYLD). [ETF Focus: Peritus High Yield]

For the five-year period ended Dec. 31, 2012, the S&P 500 had an annualized total return of 1.65%, compared with 9.53% for the Credit Suisse High Yield Index. The S&P 500 had an annualized standard deviation of 19.04% versus 12.89% for the high-yield index during the period, according to Peritus.

Some investors and advisors are using high-yield bonds as an equity proxy after the financial crisis, says Josh Brown at The Reformed Broker blog. “[I]t’s also something I’ve seen other financial advisors doing as a half-way measure toward coaxing their risk-averse clients off the sidelines without putting them into a higher equity weighting,” he wrote.

Credit spreads provide ‘cushion’

Fran Rodilosso, fixed income portfolio manager at Market Vectors ETFs, is in the camp that high-yield bonds are not in a bubble.

“I think there is a difference so far between what we are seeing at the beginning of 2013 and the type of credit bubbles we have seen historically. A bubble is built on excessive leverage, and modern bubbles have been fueled by leveraged buyouts, real estate speculation, and structured products with a high degree of embedded leverage,” said Rodilosso.

“No doubt some of these phenomena are creeping back into the market, and leverage at the company level, to generalize, did start rising during the latter part of 2012,” he added. “But whereas during a more ‘classic’ bubble a vast majority of debt issuance has historically funded takeovers, dividends, and massive capital spending, 2012’s record issuance was still, for the most part, done for the purpose of refinancing. That refinancing was done at lower interest rates, reducing the cost of debt for many borrowers, while also reducing the amount to be paid back over the next two years.”

Rodilosso manages Market Vectors Fallen Angel High Yield Bond ETF (NYSEArca: ANGL) and several other fixed-income ETFs at Market Vectors, a unit of Van Eck Global.

“Yields have been pushed down by a highly aggressive central bank policy, with the result that yield-oriented investors have been pushed into owning lower-rated credits. As a result, the yields on riskier debt are as low as they have ever been. But the credit spreads, the difference between the yield on a high yield bond and a Treasury security, are actually closer to their historic average,” he noted.

According to Rodilosso, that fact implies that there still remains some cushion in high yield bonds against a moderate rise in interest rates, a cushion he notes we are already seeing in action thus far in 2013.

“I think the point is that bonds are not ‘cheap’ in the sense that there is considerably less upside than there was a year ago, and credit markets are vulnerable to a significantly higher move in US interest rates,” he said. “But, putting aside the actions of the federal government, the private sector does not yet appear to me to be at the excessive level of leverage that would lead to imminent liquidity issues and a spike in default rates, at least not yet.”

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.