High Yield Bond ETFs: Rising on Falling Defaults

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Are high yield bond ETFs expensive right now, or cheap? The answer depends in part on investors' bond default expectations. For the past year and a half, defaults have been falling on high yield. Prices have been rising, making high yield ETFs look cheap. But can the default rate continue to go lower?Moodys thinks so. Worldwide defaults were 5% in August 2010. This is down from 5.5% in July. Moodys Investors Service sees worldwide default rates falling to 2.7% by year end. It forecasts a 2% worldwide default rate in 2011.Why are default rates important? High yield bond ETFs are portfolios of high yielding bonds (or junk bonds). These bonds pay a high yield because there is some risk that the issuer will not pay on the bond at all, in other words, default. High yield bond ETFs are popular because they pay more than investment grade debt and treasury bonds. The 30-year treasury bond currently plays less than 4%. The 10-year pays less than 3%. The 2-year Treasury bills pays just 0.5%. By contrast, high-yield bond ETFs are paying between 8% and 11% (see list at end). This makes them attractive.High-yield bond funds hold low-rated (below BBB-) speculative bonds. They have the potential to default. The leading high yield ETFs are the iShares iBoxx High Yield Corporate Bond (NYSEArca:HYG - News) and SPDR Barclays Capital High Yield Bond (NYSEArca:JNK - News). JNK usually has a more speculative (and higher yielding) portfolio compared to HYG and usually pays a point or two more in yield.Bonds in JNK include companies like Bermuda IntelSat, Harrahs, and an FRN (Floating Rate Note) issued by AIG. HYG holds paper from Aes, Chesapeake Energy, First Data. There are also many overlaps. Both ETFs hold the restructuring chemical company Lyondell, for example, and set top and communications company EchoStar.Higher yields are great but do not come without volatility that can wipe out any advantage gained from higher yields. In the past few years, high yield ETFs have traded more like equity than bonds. The chart below shows this phenomenon. It compares the return of HYG to an aggregate investment grade bond benchmark, iShares Barclay Aggregate Bond (NYSEArca: AGG - News) and the equity benchmark Standard and Poor's Depositary Receipts (NYSEArca:SPY - News).

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In 2010, HYG is holding up despite a lower drifting SPY. This suggests that investors are willing to accept some volatility and to pay up for good yields. But the chart shows how quickly high yield can move when expectation of default increase. In January 2009, the market assessed the risk of default at as high as 18%, a notch above the 16% rate achieved during the height of the depression in the thirties. This took HYG down sharply (raising its yield). As the default outlook improved, HYG shot back up, moving in the second half of 2009, faster even than the equity benchmark SPY.The chart provides an indication of the rollercoaster ride investors can expect with high yield debt: equity-like volatility. The treasury bonds and agency paper held in the fund AGG trade primarily on interest rate expectations and investor concern for safety. High yield bond ETFs will be hurt by higher rates of course, but they are less sensitive to interest rate changes compared to treasuries and high grade corporate bond ETFs. They are more sensitive to the market cycle.With so much volatility, why not just stick with more reliable Federal Government Bonds, U.S. Agency bonds or high-grade corporate bonds issued by reliable trusted companies like McDonalds or General Mills? The reason is that compared to safer fixed income instruments speculative bonds simply pay more interest to compensate for the additional risk. As long as they don't default, it is worth it. In 2010, HYG appears to be trending more like a bond fund.Additional risk is measured in terms of the probability of a bond defaulting and the recovery rate (the measure of principal recoverable should a bond default). Historically there is a 3-4% default rate and a recovery rate of 40%-50% on bonds, 70% on loans. But both the default rate and the recovery rate vary depending on the market climate. When defaults decline (or recovery rates rise) high yield bonds seem safer-- prices rise and yields fall. When defaults rise (or recovery rates fall), the opposite happens: to attract capital on new issues, yields rise and prices fall.The list below shows yields in Q3 2010 for high yield bond ETFs and their expense ratios.iShares iBoxx High Yield Corporate Bond (NYSEArca:HYG - News), expense ratio: 0.50, yield: 9.0%SPDR Barclays Capital High Yield Bond (NYSEArca:JNK - News), expense ratio: 0.40, yield: 10.8%PowerShares Fundamental High Yld Corp Bd (PHB), expense ratio: 0.50, yield: 8.4%Jonathan Bernstein has been writing about ETFs since 2003 and is the author of Sector Trading: A Year in Exchange Traded Funds.

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