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Junk Bond ETFs Still Appealing, Says S&P

Junk Bond ETFs Still Appealing, Says S&P

Despite falling yields, income-starved investors continue to embrace high-yield bond ETFs. Coming off almost $10 billion in inflows last year, junk bond ETFs raked in $1 billion in new assets in the first four months of 2013, according to a new research note by S&P Capital IQ, fortifying the notion that today's low interest rate environment has bolstered the allure of high-yield bond funds.

"Investor demand for higher-yielding securities helped push new corporate speculative-grade bond (BB or below) issuance to a record $98 billion during the first four months of 2013, according to Standard & Poor's Global Fixed Income Research
(which operates independently from S&P Capital IQ)," said the research firm in the note.

Although investors have been warm to junk bond ETFs for several years, spreads between high-yield bonds and U.S. Treasury securities have plunged this year.

"While the spread between investment-grade rated bonds and Treasuries has held firm since the beginning of 2013 at 179 basis points, the speculative-grade spread has declined approximately 20% from 554 basis points at the beginning of 2013," said S&P Capital IQ in the note. "Relative to the last five years,the speculative-grade spread is 39% below the 745 basis points average."

Even with declining spreads and yields on junk bonds, S&P is bullish on some of the largest high-yield bond ETFs. S&P Capital IQ has Overweight ratings on the iShares iBoxx $ High Yield Corporate Bond Fund (NYSE: HYG) and the SPDR Barclays High Yield Bond ETF (NYSE: JNK), the two largest junk bond ETFs by assets. S&P also has an Overweight rating on the PIMCO 0-5 Year High Yield Corporate Bond Index ETF (NYSE: HYS).

Just a few weeks shy of its second birthday, the PIMCO 0-5 Year High Yield Corporate Bond Index ETF has the shortest duration of the three funds highlighted by S&P, meaning the fund is the least sensitive to potential interest rate increases. Home to over $2.2 billion in assets under management, HYS has a distribution yield of 3.67 years and an effective duration of just 1.84 years, according to PIMCO data.

By comparison, the iShares iBoxx $ High Yield Corporate Bond Fund, the largest junk bond ETF by assets with over $15.8 billion, has an effective duration of 3.83 years. The SPDR Barclays High Yield Bond ETF has a modified adjusted duration of 4.11 years. Although it has the longest duration of the three ETFs, JNK has the highest current yield at 6.93 percent.

Of course, investors need to consider default rates with any fixed income investment, but that is especially true of junk bonds. S&P is forecasting an increase in default rates over the next 10 months.

"Meanwhile, Standard & Poor's Ratings Services expects that the U.S. corporate trailing 12-month speculative-grade default rate will increase to 3.3% by March 2014, from the 2.5% achieved in the 12 months ended March 2013. The baseline forecast is partially based on assumptions that the U.S. economy will grow by 2.7% in 2013 and the unemployment will decline to less than 7% by the first quarter of 2014. While a higher default rate is a modest concern, it should be noted that the long-term average default rate in the 1981-2012 period was 4.5%," according to the note.

Year-to-date, HYG is up 4.4 percent while HYS and JNK are both higher by 4.2 percent. HYS has annualized volatility of 9.69 percent since inception while HYG has a three-year standard deviation of just over eight percent, according to iShares data.

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