Junk Bond ETFs: Are 5% Yields Worth the Risk?

ETF Trends

High-yield corporate bond ETFs have been immensely popular but yields have been pushed so low that newcomers may not be getting adequately compensated for the risk of investing in speculative-grade debt.

The recent pullback in high-yield ETFs appears to have shaken out at least some of the “hot” money.

The iShares iBoxx High Yield Corporate Bond Fund (HYG) and the SPDR Barclays High Yield Bond ETF (JNK), the two largest funds in the category, have experienced net outflows of $731 million and $514 million, respectively, so far this year, according to IndexUniverse data. The ETFs are paying 30-day SEC yields of about 5%.

The outflows aren’t significantly large when considering how big these ETFs are, and the massive inflows they’ve attracted over the past year from yield-starved investors. [High-Yield Bond ETFs: Rush for the Exits?]

Still, there are worries about how much gas is left in the tank for high-yield bonds after such as strong run. The junk debt ETFs posted total returns well over 10% last year.

“Prices are now near all-time highs and yields near all-time lows,” Schwab analysts wrote in a recent commentary. “We think it will be difficult to continue the strong performance going forward. In fact, we think there are increased risks in the high yield market, and believe investors should be cautious when investing in the asset class.”

‘Return expectations must be tempered’

Moody’s recently warned that junk bond covenant quality fell to an all-time low in January.

However, the dilemma for investors is that there simply aren’t many alternatives for yield with the Federal Reserve committed to keeping short-term interest rates near zero. They’re being forced to take on more risk in search of income, hence the popularity of junk bonds and other high-yield sectors.

Also, some portfolio managers point out that while junk-bond yields are at historic lows, the spread over Treasury bonds is still reasonable. [High-Yield Bond ETFs: Too Risky After Big Rally?]

Yet the Schwab analysts are warning investors that there may not be much room for high-yield bond prices to maintain their advance.

“Although the average coupon rate of 7.8% may help high yield bonds generate positive total returns, we believe that it will be difficult to generate another year of double-digit total returns in 2013. In fact, we believe that risks to the market have increased,” they wrote.

They also point out that for the first time since 2009, the sub-investment grade market experienced more downgrades than upgrades, even though overall fundamentals have been improving due to companies lowering overall debt levels and boosting cash balances.

“Although the high yield market has generated strong returns over the past two years, we think the risks have increased. We believe total return expectations must be tempered, due to the recent negative trends,” the Schwab analysts said.

SPDR Barclays High Yield Bond ETF

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Full disclosure: Tom Lydon’s clients own HYG and JNK.

The opinions and forecasts expressed herein are solely those of John Spence, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.

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