High-yield bond investors are now exposed to rising credit risks, especially as the Federal Reserve plans to hike interest rates. Those risks could be heightened by a rising number of defaults by energy sector issuers.
Risky borrowers “cannot pay down debt because cash flow generation is weak, and now interest costs are rising,” according to the UBS strategists. “So the Fed is explicitly condoning rising default rates. Finally, it is our humble belief that the consensus at the Fed does not fully understand the magnitude of the problems in corporate credit markets and the unintended consequences of their policy actions.”
According to ratings agency Standard & Poor’s, default rates are already inching higher, with the trailing 12-month rate rising to 2.8% in November, the highest level in three years, reports Jeff Cox for CNBC. The ratings firm anticipates defaults to hit 3.3% by September 30, 2016.
High-yield bond exchange traded funds, such as the iShares iBoxx $ High Yield Corporate Bond ETF (NYSEArca: HYG) and the SPDR Barclays High Yield Bond ETF (NYSEArca: JNK), the two largest junk bond ETFs by assets, are among the funds that are viewed as vulnerable to increasing energy defaults.
“A 4.5% 2016 high yield default rate equates to $66 billion of defaults and would be the fourth highest default total since 2000. This would be close to the $78 billion amassed in 2001 but well below the record $119 billion posted in 2009,” said Fitch Ratings in a note posted by Amey Stone of Barron’s.
The popular high-yield ETFs include significant exposure to lower quality speculative-grade debt that are at greater risk to default. For instance, JNK has a 13.8% tilt toward CCC or lower-rated debt and HYG has 8.8% in CCC-rated securities. [Bond ETF Outflows Picking Up]
When energy and mining issues are removed from the equation, the high-yield default considerably improves.
“Removing energy and metals/mining from the index, the remainder of the high yield universe is expected to finish 2016 with a 1.5% default rate, which is below Fitch’s non-recessionary average of 2.1%,” Barron’s reports, citing Fitch.
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. [The Many Faces of High-Yield Bond ETFs]
iShares iBoxx $ High Yield Corporate Bond ETF
Tom Lydon’s clients own shares of HYG and JNK.