The two largest junk debt ETFs were set for their first back-to-back losses for the first time in nearly a month after Federal Reserve Chairman Ben Bernanke warned investors on the risks of stretching for yield in a low-rate market for bonds.
“In light of the current low interest rate environment, we are watching particularly closely for instances of ‘reaching for yield’ and other forms of excessive risk-taking, which may affect asset prices and their relationships with fundamentals,” Bernanke said in a speech Friday.
The iShares iBoxx High Yield Corporate Bond (NYSEArca: HYG) and SPDR Barclays High Yield Bond (NYSEArca: JNK) were in the red for a second day.
The speculative-grade ETFs have been strong performers with average yields in junk bonds falling below 5% for the first time ever. Bond yields and prices move in opposite directions. [Junk Bond ETFs Still Cruising as Yields Plumb Fresh All-Time Lows]
“Loosening credit standards have made it easier for corporations to issue debt. Lower interest rates, a rebounding economy and cost-cutting measures are reducing the short-term potential for default. All of these factors bode well for high-yield bonds,” writes Charles Rotblut, editor at the American Association of Individual Investors (AAII) Journal.
Yet he notes that high-yield bonds are called “junk” for a reason. The issuers have lower credit ratings so the bonds pay higher yields to compensate investors for the default risks.
“I can empathize with investors who are reaching out to high-yield bonds for reasons of income. Not only are Treasury yields low, but we are also seeing yields on dividend-paying stocks fall as well,” Rotblut said. “What has me worried, however, is that some investors are ignoring the risks of higher yields. Getting an extra few percentage points in yield right now may not be enough to offset a large future decline in price.”
Next: What high-yield credit spreads are saying
Still, investors just don’t have many options for “safe” yield. Treasury yields are higher in May but the 10-year note is still paying less than 1.9%.
Yields on junk bonds continue to decline, driven by unprecedented demand and heavily influenced by the $80 billion in fixed-income assets being purchased by the Fed every month, says Fran Rodilosso, fixed-income portfolio manager at Market Vectors ETFs.
Even though yields in junk debt are extremely low on an absolute basis, the spread versus Treasuries isn’t out of control. The credit spread was extremely tight in 2007 before the financial crisis.
“The credit spread is actually high in comparison with other periods when [high-yield corporate] default rates were as low as they are currently, which is around 3%,” Rodilosso said.
iShares iBoxx High Yield Corporate Bond
Full disclosure: Tom Lydon’s clients own HYG and JNK.