How credit risk equations change for high yield bond ETFs

Market Realist

Will investors prefer investment grade over high yield in 2014? (Part 4 of 7)

(Continued from Part 3)

Monetary policy

The present accommodative monetary policy environment has seen yields for fixed income securities fall to historic lows, including high-yield fixed income ETFs like JNK and HYG. The SPDR Barclays Capital High Yield Bond ETF (JNK) has provided total returns of 7.87% over the past year and 25.72% over the past three years. The iShares iBoxx $ High Yield Corporate Bond ETF (HYG) has clocked total returns of 26.23% over the past three years and 7.79% over the past one year (to February 28, 2014).

The low yields on investment-grade fixed income securities was partly responsible for forcing investors to put their money into non–investment grade bonds, as high-yield bonds offer a higher yield compared to investment-grade bonds since they’re rated riskier securities. The difference in yields between investment-grade and non–investment grade bonds is called the “credit spread,” or the compensation for investors assuming higher credit risk.

The low interest rate environment has also made it easier for high-yield issuers to meet their interest commitments and refinance older and costlier debt with cheaper funding, perhaps by lower rates than might be justified, were it not for the Fed’s accommodative monetary policy. This factor has not only lowered interest rates across the lending spectrum but also meant that below–investment grade rated companies have been able to borrow greater amounts at lesser costs.

According to ratings agency Standard & Poor’s, 91% of investment-grade companies had a stable or positive outlook compared to 86% of non–investment grade or speculative-grade companies—companies rated below BBB- as of November 30, 2013. However, the up/down ratio, or the total number of credit rating upgrades divided by the total number of credit rating downgrades, has come down to 1.02 in Q1 2014, compared to 1.18 in Q4 2013. Other factors remaining constant, this would indicate that credit spreads for high-yield bonds versus investment-grade bonds (LQD) may increase going forward. A higher credit spread will imply greater risk, higher yields, and lower prices for high yield bonds going forward. While it’s still early in the year for the up/down ratio to be really comparable to last year, the number of credit rating upgrades almost equals the number of downgrades for high-yield issuers this year, compared to 92 upgrades versus 78 downgrades in Q4 2013.

Two ETFs with exposure to the investment-grade bond market in the U.S. are the Vanguard Total Bond Market ETF (BND) and the iShares iBoxx $ Investment Grade Corporate Bond Fund (LQD). BND tracks the Barclays Capital U.S. Aggregate Bond Index, which is composed of investment-grade bonds in the U.S., including government, corporate, and international dollar-denominated bonds, as well as mortgage-backed and asset-backed securities with a maturity in excess of one year. LQD tracks the iBoxx $ Liquid Investment Grade Index, which provides a broad representation of the U.S. dollar–denominated liquid investment-grade bond market in the U.S. The top ten holdings in LQD include Verizon Communications at 6.55% (VZ) and Apple at 2.4% (AAPL).

To find out more about how increased credit risk will affect both high yield (JNK) and investment grade bonds (BND), read on to Part 5 of this series.

Continue to Part 5

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