Investors have piled into speculative-grade debt and junk bond exchange traded funds since the credit crisis. However, some caution that as investors bought up the fixed-income asset, all the value has been squeezed out, leaving many exposed to greater risks.
Jeffrey Gundlach, head of DoubleLine Capital LP, argues that with borrowing costs for junk-rated companies touching a record low, speculative-grade debt no longer provides enough of a buffer to hedge against rising Treasury yields, Bloomberg reports.
“They’ve squeezed all the toothpaste out of the tube,” Gundlach said in the article. “There is interest-rate risk that’s just being masked by fund flows holding up the prices of junk bonds.”
Junk bonds have gained 148% since the end of 2008 as loose monetary policies pushed investors into high-yield assets in search of income. Globally, there is now $1.97 trillion in junk bonds, compared to less than $1 trillion in March 2009. [Investors Flocking to High Yield Bond ETFs]
Over the past five-years, the iShares iBoxx $ High Yield Corporate Bond ETF (NYSEArca: HYG) has produced an average annualized return of 15.1% while the SPDR Barclays High Yield Bond ETF (NYSEArca: JNK) rose 17.3%. HYG now has a 4.48% 30-day SEC yield and JNK has a 4.87% 30-day SEC yield.
Junk bond investors are demanding 3.78 percentage points more than similar-maturity Treasuries as of March 5, the lowest spread since 2007. Some argue that the difference does not adequately cover the risk.
“We’re at an extreme over-valuation,” Martin Fridson, chief executive officer of FridsonVision LLC, said in the article. “When you’re not compensated adequately for the risk, you do tend to get punished for it. If the Fed is still sufficiently energetic about it, they could keep it at an over-valuation through all of 2014.”
With junk bonds showing signs of being overbought, Gundlach has lowered his allocation in speculative-grade debt in his Core Fixed Income Fund to 3% as of the end of last month from the expected average of 10%. [Junk Bond ETFs Gain Some Fans]
Interest rate risk seems to be the main driver of concern as credit risk remains muted. Speculative-grade global default rate is expected to hit 2.1% in December, down from 2.9% as of the end of 2013, according to Moody’s
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 JNK and HYG.