High-yield, junk bonds and related ETFs have grown in popularity in a lower-for-longer rate environment, but the speculative-grade fixed-income market may be flashing early warning signals.
Year-to-date, the iShares iBoxx $ High Yield Corporate Bond ETF (HYG) brought in $2.9 billion in net inflows while the SPDR Barclays High Yield Bond ETF (NYSEArca: JNK) attracted $2.6 billion in inflows, according to ETFdb data.
Income-minded investors have plunged back into junk bonds in search of yields as rates declined in response to heightened demand for safety and the Federal Reserve’s looser monetary policy outlook. The Fed is even widely expected to cut interest rates by another quarter percentage point at its upcoming meeting this week.
However, bond specialists are cutting back on high-yield debt to hedge against potential losses in case the credit cycle turns, the Wall Street Journal reports.
A key measure shows that the risk in the junk bond market is at its highest level since 2016. According to data from S&P Global Ratings, the U.S. distress ratio, or the proportion of junk bonds that yield more than 10 percentage points above U.S. Treasuries, rose to 9.4% in August compared to 6% in July.
Bond yields rise when…
Bond yields rise when investors demand greater compensation to hold a riskier debt security, so a rising distress ratio reflects a sharp change in risk appetite.
“We think fundamentals are weakening even if the U.S. avoids a recession,” Matt Eagan, co-manager of Loomis Sayles Bond Fund, told the WSJ.
While falling earnings and rising debt loads contribute to credit quality, access to new capital is equally important to speculative-rated companies, which usually lack the cash to pay off debt and would typically rely on refinancing.
Related: Billions Flow into Corporate Bond ETFs
However, this has become more costly in recent weeks as investors shifted away from below-investment-grade rated borrowers to companies with lower credit risk. According to Lipper data, investors funneled $20 billion into investment-grade corporate bonds funds in the six weeks ended September 11 while yanking $6 billion from mutual funds and ETFs that cover high-yield bonds and leveraged loans.
Eagan also warned that while default rates remain low, speculative-grade debt issuers can also suffer from downgrades to their credit ratings due to declining earnings, rising debt or both.
“A lot of people think mostly about defaults and don’t realize the losses that can come from downgrades,” Eagan added.
For more information on the fixed-income market, visit our bond ETFs category.