Junk bond-related exchange traded funds that that cover some of lowest-rated companies may be in for more pain ahead as distressed debt levels in the U.S. rise.
According to ratings agency Standard & Poor’s, the number of companies with the lowest credit ratings and negative outlooks increased to 195 in December, the highest level since March 2010, reports Matt Krantz for USA Today.
The debt markets are beginning to weigh in on the double whammy from rising interest rates and weakening profits in several sectors, notably commodities-related producers.
For instance, among the weakest areas in the debt market, oil and gas sector makes up 34 of the lowest-rated credit issuers with negative outlooks in December. Additionally, financial companies were a close second, with 33 of the weakest links, according to the S&P. [Rising Default Risks in Junk Bond ETFs]
Oil and gas sector makes up the largest percentage of distressed debt at 37% after the plunge in crude oil prices weighed on profits and added to uncertainty for the sector ahead. Meanwhile, metals, mining and steel are also under pressure, with a 72% distress ratio, due to falling demand for industrial metals, notably from China and a weakening global economy.
Consequently, the more pessimistic outlook has dragged on the high-yield bond market. For instance, the SPDR Barclays High Yield Bond ETF (NYSEArca: JNK) fell 6.9% and iShares iBoxx $ High Yield Corporate Bond ETF (NYSEArca: HYG) dropped 5.1% year-to-date.
The two junk bond ETFs include some lower quality speculative-grade debt that are more at risk of defaults. JNK’s portfolio includes 15.6% CCC or lower-rated bonds, 41.1% B and 40.7% BB. HYG includes CCC 9.4%, 38.4% B and 49.8% BB.
Moreover, the high-yield bond ETFs are exposed to the more distressed areas of the market. For example, HYG includes 10.6% energy, 5.3% basic industry and 5.9% finance companies.
Alternatively, fixed-income investors may consider high-yield bond funds that lean toward higher quality debt. For instance, the Market Vectors Fallen Angel High Yield Bond ETF (NYSEArca: ANGL) tracks so-called fallen angel, speculative-grade debt, or those bonds that were born with investment-grade ratings but were later downgraded to junk territory. Fallen angel issuers tend to be larger and more established than many other junk bond issuers. Furthermore, since these fallen angels were formerly on the cusp of investment-grade status, this group of junk bonds typically has a higher average credit quality than many other speculative-grade debt-related funds. ANGL’s credit qualities include BBB 2.9%, BB 74.6%, B 12.5%, CCC 4.1% and CC 0.3%.
The PowerShares Fundamental High Yield Corporate Bond ETF (NYSEArca: PHB), which tracks the RAFI Bonds US High Yield 1-10 Index, leans toward slightly higher quality corporate debt securities than its major competitors. The underlying Research Affiliates index implements a fundamental or smart-beta indexing methodology that focuses on four factors, including gross sales, gross dividends, cash flow and book value of assets for each issuer. The end result is an index of company debt with higher credit ratings, including some low-investment-grade BBB 15%, along with speculative-grade BB 59% and B 25%. [Quality Matters in Junk Bond ETFs]
The slightly higher credit quality may also explain why ANGL and PHB are performing or at least not doing as bad as HYG and JNK. Year-to-date, PHB fell 2.9% and ANGL dipped 1.2%. [A Higher Quality Junk Bond ETF That is Outperforming]
For more information on the speculative-grade debt market, visit our junk bonds category.
Max Chen contributed to this article.