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Is It Time To Buy High Yield ETFs Again?

Cinthia Murphy

High-yield bond ETFs went through the grinder late last year, dropping to multiyear lows as fears about widespread defaults—linked largely to the decline in oil prices—mounted. But in recent days, they seem to have found a footing, or at least enough of one to fuel the question: Is it time to get back into this segment?

UBS’ call last fall for default rates to possibly double by the third quarter of 2016 is still reverberating among investors. If UBS is right, defaults in high yield—led by energy, metals, mining and commodity companies in general—could hit 4.8% by Q3, up from 2.6% last September, and from 1.6% in September 2014, according to Bloomberg. That’s a red flag.

Sounding Alarms

Money managers such as Jeffrey Gundlach have long been warning about the dangers of high-yield bonds, calling junk bond funds possibly one of the worst investments an investor could make right now. His views aren’t new—he’s been tooting this horn for months now—but he recently reinforced them in a panel discussion, as reported by Forbes.

To people like Gundlach, owning ETFs such as the SPDR Barclays High Yield Bond ETF (JNK | B-68) and the iShares iBoxx USD High Yield Bond Corporate ETF (HYG | B-68) carries a lot risk at the moment with not enough reward.

But what if default rates don’t increase? JNK and HYG are shelling out 30-day yield of about 8-9%, levels that aren’t only historically high, they are recessionarylike levels. If the U.S. economy doesn’t sink into a recession, and default rates don’t jump—as some fear—high-yield bonds could in fact be very cheap and attractive.

Battered Bond ETFs Rising

In the past month, HYG and JNK both dipped to their lowest levels since mid-2012, but managed to bounce off, and have been on the rise since. Both funds are now in the black for the past 30 days, as the chart below shows:

Chart courtesy of StockCharts.com

In the month of February alone, investors have poured nearly $600 million of fresh net assets into HYG, and some $263 million into JNK. Flows into both funds are net positive so far for 2016. That’s a clear turnaround from the action we saw in late 2015 when JNK bled $1.7 billion in two months, and HYG faced $165 million in net redemptions.

There are a few things investors should consider if thinking about getting back into this segment.

Masking Inconsistent Yields

First, note that chasing that 9% yield alone can be tricky. Consider that the yield of 9% “masks a tremendous bifurcation in the market,” as Greg Zappin, CFA, managing director and portfolio manager at Penn Mutual Asset Management, put it.

“High-yield credit is really two markets, with a large percentage [yielding] more than 15% and a large percentage trading inside of 6.5%,” he told ETF.com. “There are some company-specific, tactical trades that look attractive in high-yield credit. In general, though, we remain cautious and are not counting on an extended rally in risk markets.”

The reason Zappin remains guarded about this space is that the high-yield market is highly correlated with equities, and both markets have been high correlated with oil prices, he says. It’s correlations, more than default risk, that is keeping him at bay for now.

Equities & Oil Are Key

“You need to have a constructive view on equity markets and oil prices to be bullish on high yield in aggregate,” he said. “Default risk of energy companies is a concern, but largely priced into the market.”

From a technical—and more tactical—perspective, high-yield bond ETFs could prove to be a great short-term opportunity, but not a long-term one, says Steve Blumenthal of CMG Capital Management Group.

“A simple smoothed moving average can tell us a lot about both the short-term and the longer-term trends in high yield: It’s a short-term buy for now, but trading it with stops in place for the overall longer-term trend picture remains less favorable,” Blumenthal said.

Default Risking Rising

“The yield spreads are very attractive; however, default risk is rising,” he said. “Absent recession, high-yield ETFs are attractive given the higher yields created by the recent sell-off. But with a recession—and we will get another recession—we will see defaults rise sharply. That will drive prices meaningfully lower and yields higher.”

Remember that in 2008, we hit 20% yields—levels that we could see again if the U.S. enters a recession, Blumenthal says.

And there’s also the fact that the malaise in high yield doesn’t extend only to energy and oil-linked companies.

Other Sector Funds Stumbling

The latest research from S&P Dow Jones Indices’ Jason Giordano show that high-yield credit default spreads have widened in the past year, but that widening isn’t only due to the trouble in the energy sector.

“The widening also represents the overall discomfort with the amount of leverage companies have on their balance sheets within the broader high-yield market,” Giordano said.

To that point, a look at the latest additions to the list of qualifying constituents for the S&P U.S. Distressed High Yield Corporate Bond Index—a list that has grown “dramatically since August 2014”—shows that these newcomer names aren’t only energy companies; they are also telecom, financial, consumer discretionary and materials names, he notes.

To investors considering getting back into the high-yield segment, Blumenthal has one piece of advice: “Stay tactical.”

Contact Cinthia Murphy at cmurphy@etf.com

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