Yield premiums on speculative-grade debt and junk bond exchange traded funds are steadily rising, reflecting increased default concerns ahead of the Federal Reserve’s expected interest rate normalization.
Looking at the two largest junk bond ETFs, the iShares iBoxx $ High Yield Corporate Bond ETF (NYSEArca: HYG) has a 6.62% 30-day SEC yield and SPDR Barclays High Yield Bond ETF (NYSEArca: JNK) has a 6.92% 30-day SEC yield.
Meanwhile, the BofA Merrill Lynch US High Yield Master II Effective Yield was hovering around 7.92%. In contrast, yields on benchmark 10-year Treasuries were at 2.25% Thursday.
The widening credit spread, or percentage point difference in yields between junk debt and investment-grade bonds, reveals potential concerns for the overall creditworthiness of the private sector since the deterioration of Corporate America’s ability to service debt will likely come first from junk-rated issuers, reports Gavin Jackson for the Financial Times.
With yields rising, companies will have a harder time paying back debt, which could lead to higher defaults.
While junk bonds were typically better off during a rising rate environment, speculative-grade debt may experience greater volatility this time around. Historically, higher-yielding junk bonds helped provide a bigger cushion to absorb the negative effects of higher rates, and the riskier debt tends to do better in an expanding economy where the central bank would feel it safe to raise rates.
However, the current fixed-income market may be distorted due to years of quantitative easing, which has pushed down bond yields across the board.
Additionally, many speculative-grade energy and materials debt issuers are under pressure after crude oil and metals prices tanked over the past year. [The Many Faces of High-Yield Bond ETFs]
ETF investors can hedge against the rising credit risk through a credit default swaps-related ETF, the ProShares CDS North American HY Credit ETF (BATS: TYTE). A credit default swap is essentially insurance or protection against non-payment of a debt obligation. If interest rates spike, lowly-rated borrowers that issued high-yield bonds at today’s low rates could be forced to pay old debt with new debt issued at higher rates, a scenario that could increase the allure of CDS. Potential investors, though, should be aware that TYTE is still rather small with low average value, so people should utilize limit orders to better control trades.
For more information on the speculative-grade debt market, visit our junk bonds category.
Max Chen contributed to this article.
The opinions and forecasts expressed herein are solely those of Tom Lydon, 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.