What's Behind the Recent Junk Bond ETF Pullback

The iShares iBoxx $ High Yield Corporate Bond ETF (NYSEArca: HYG) and the SPDR Barclays High Yield Bond ETF (NYSEArca: JNK), the two largest high-yield corporate bond exchange traded funds, and rival high-yield corporate bond funds sold-off last week, prompting some market observers to speculate that could be a negative sign for riskier assets.

However, some bond market participants believe the recent pullback in high-yield debt was not all that surprising, particularly when noting how tight spreads had become.

“The sell-off should not have been much of a surprise given how tight high yield spreads had become. To start November, high yield bond spreads—a measure of credit risk—were 34% below their 20-year median,” said State Street Global Advisors (SSgA). “These spreads have compressed by more than 150 basis points in the last year alone. A little mean reversion was therefore not unfathomable given the yearlong rally in high yield.”

HYG’s underlying index, the Markit iBoxx USD Liquid High Yield Index, also requires holdings to have at least $400 million in par value, and the debt issuer must have at least $1 billion in total debt outstanding. Due to their similar focus on liquidity, the two high-yield bond ETFs have similar portfolios.

Senior secured floating-rate bank loans are seen as a way for fixed-income investors to maintain yield generation while hedging rate risk. Senior secured floating-rate loans have, as their name suggests, a floating interest rate component, which fluctuates with market rates. Because rates are typically reset once per quarter, senior loans typically have low durations. Since the senior loans have rates that adjust periodically, the floating-rate loans also offer investors an alternative method of earning yields while mitigating interest-rate risk.

For instance, the PowerShares Senior Loan Portfolio (NYSEArca: BKLN), the largest senior loan-related ETF on the market, has an average 45.09 day to reset period. Other options include the Highland/iBoxx Senior Loan ETF (NYSEArca: SNLN), and actively managed SPDR Blackstone/GSO Senior Loan ETF (NYSEArca: SRLN) and First Trust Senior Loan ETF (NasdaqGM: FTSL).

Junk bond ETFs could see near-term relief if the Trump Administration’s tax reform effort springs back to life, but that is a big “if.”

As jitters arose that tax reform might go the way of health care reform at the same time the market faces a looming debt ceiling debate, risk assets sold off,” said SSgA. “High yield did not lead the way. High yield fell more than large-cap stocks, as represented by the S&P 500 Index. But small-cap stocks, which are more domestically oriented than large caps and tend to have higher taxes, fell more than high yield.”

For more on bond ETFs, visit our Fixed Income category.

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