High-yield, junk bond exchange traded funds have been experiencing large swings over the past few months and the asset class could remain vulnerable as a combination of Federal Reserve policy, low liquidity in the underlying market and crowded trades fuel volatility.
Over the past three months, the iShares iBoxx $ High Yield Corporate Bond ETF (NYSEArca: HYG) has dipped 1.3% and the SPDR Barclays High Yield Bond ETF (NYSEArca: JNK) fell 1.8%. [Shake Up in Junk Bond ETFs]
After the search for yield turned into a search for low-quality bonds, many investors are now exposed to greater risks, and Alberto Gallo, head of macro credit research at RBS, on Financial Times argues that the market could continue to see corrections ahead. Specifically, Gallo points to some factors that are contributing to the heightened volatility in high-yield bonds.
First off, the Fed is more inclined to hike rates due to a falling U.S. unemployment rate, which is now at 5.9%, and an improving economy. [Why Corporate Bond ETFs Could Face Pressure As Rates Rise]
“Some market participants believe other central banks (European Central Bank, People’s Bank of China) may be ready to pick up the slack as the Fed stops expanding its balance sheet,” Gallo said. “But history shows that a change in Fed policy rarely comes without volatility.”
Policy makers are also voicing concern over risky assets. The Fed has already issued a warning on high-yield bonds and macro-prudential measures on leveraged loans in an attempt to curb overexuberance.
“Dallas Fed President Richard Fisher said, investors are seeing the world through ‘beer goggles,'” Gallo added.
Meanwhile, in Europe, the European Central Bank is coming up against a wall as it tries to implement a bond purchasing program. So far, the central bank lacks the co-operation of its many member states. Additionally, default risk in Europe is back as growth stagnates.
Consequently, the problems in the Eurozone have weighed on the international high-yield ETF, the Market Vectors International High Yield Bond ETF (NYSEArca: IHY), which includes a 38.2% exposure to the Eurozone, along with 52.9% to the U.S., is down 4.2% over the past three months. Other international junk bond ETFs with heavy Europe exposure have also faltered, with the iShares Global ex USD High Yield Corporate Bond ETF (NYSEArca: HYXU) down 8.0% and SPDR Barclays International High Yield Bond ETF (NYSE: IJNK) down 4.1%.
Gallo also warns that many investors are in the same trade, with the high-yield, junk bond market growing overcrowded.
Lastly, the junk bond market is notoriously known for its liquidity issues, and with a crowded market, the exit door looks small.
“Some investors, such as BlackRock, are calling for a radical reform of bond markets, to improve standardisation and liquidity,” Gallo said. “But for now, the dealers’ capacity to absorb volatility remains limited.”
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 HYG, JNK.