Benefit of Lower Duration Junk ETFs: Less Energy Exposure

Oil’s fall has been predictably problematic for a plethora of futures- and equity-based exchange traded funds. Pressure on the oil patch is also translating to elevated concerns about defaults among energy sector issuers in the high-yield bond market.

Eager to tap North American shale plays from the Eagle Ford in South Texas to North Dakota’s Bakken Shale and a host of others, mid-level and smaller exploration and production companies have become some of the most prolific issuers of U.S. junk bonds in recent years.

Some market observers believe that until crude’s recent tumble, investors had not factored falling oil prices into lower liquidity market segments, including master limited partnerships and junk bonds. With the United States Oil Fund (NYSEArca: USO) off 28% over the past 90 days, investors are now being forced to assess the exposure of their junk bond ETFs to the energy sector. [Oil Slicks for Junk Bond ETFs]

“Energy exposure has increased significantly over the last 5 years in investment grade and high yield credit indexes. Investment grade issuers have refinanced a lot of existing debt, and have issued new debt to fund capital projects.  High yield energy exposure, which is the highest, is driven by new companies issuing high yield debt to enter the booming oil/shale industry,” said State Street Global Advisors Vice President and head of research Dave Mazza in an email to ETF Trends.

Ongoing weakness in oil prices could create added stress for already cash-strapped high-yield E&P issuers. With oil prices tumbling, production costs at various shale formations high and the ability of some shale operators to generate cash challenged, some money managers are forecasting a raft of junk defaults in the energy sector. [Warnings for Junk Bonds With Big Energy Exposure]

“If oil prices continue to fall precipitously, then credit issuers in the energy sector will likely be under greater stress as their profitability and for servicing debt are a function of energy prices. In that scenario credit spreads are likely to widen further, defaults would increase and negative returns from the energy sector could be a drag on overall high yield performance,” adds Mazza.

However, investors can maintain corporate debt exposure, even of the high-yield variety, while reducing energy sector risk by doing something many have already been doing: Managing interest rate risk by flocking to lower duration junk bonds and the corresponding ETFs.

The SPDR Barclays High Yield Bond ETF (NYSEArca: JNK), the second-largest U.S. junk bond ETF, allocates 17% of its weight to the energy sector. JNK is down 4.6% over the past 90 days. Conversely, the SPDR Barclays Short Term High Yield Bond ETF (NYSEArca: SJNK) has a 16% weight to the energy sector, but that slight difference from JNK coupled with a duration of just 2.39 years has helped SJNK outpace JNK by nearly 110 basis points over the past 90 days. Investors have poured $1.4 billion in SJNK this year. [Institutional use of ETFs on the Rise]

The SPDR BofA Merrill Lynch Cross Over Corporate Bond ETF (NYSEArca: XOVR) features an energy sector weight of 10% and that ETF is down just 2% over the past three months.

XOVR includes so-called cross over debt, which has less credit risk than many high yield bonds and generally offers higher yields than most investment grade bonds. Nearly half the ETF’s weight is allocated to bonds rate Baa or lower so the fund is not a pure junk bond ETFs. However, XOVR features a 30-day SEC yield of 3.6% and that comes with a duration of 5.82 years.