A Favored Trade Could Be Falling Out Of Favor

Through years of declining interest rates, income-starved investors were not shy about pouring into high-yield corporate bonds with exchange-traded funds increasingly becoming the preferred avenue for accessing that asset class.

Today, the iShares iBoxx $ High Yield Corporate Bond ETF HYG is home to $19.4 billion in assets under management, making it the largest junk bond ETF and one of the largest corporate bond ETFs overall. HYG and rival junk bond ETFs are generating positive returns this year, but some market observers believe this trade could see waning momentum.

“The yield on U.S. high yield has slipped as spreads have compressed,” said BlackRock in a note out Monday. “At 5 percent, high yield does not seem to offer particularly generous returns, especially when you consider that the long-term average is closer to 10 percent. Still, a 5 percent yield looks enticing given the alternatives in other bonds.” 

Still A Yield Play

Understanding investors' previous enthusiasm for funds such as HYG is easy: Much of it boils down to yield. Even following close to two years of steady appreciation, HYG still sports a 30-day SEC yield of 4.7 percent. That is more than double what investors get on 10-year Treasuries and well above the comparable yield on investment-grade corporate debt funds.

Income-seeking investors have been compelled to embrace high-yield bonds since the start of last year because volatility for the asset class has been benign as have default rates.

“As with stocks, high yield bonds have had a remarkably quiet year,” said BlackRock. “According to Bloomberg, trailing 30-day volatility on two popular high yield ETFs is below 3 percent. Longer-term measures of volatility are also compressed. This is important. Low expected or ex-ante volatility historically translates into a high expected Sharpe Ratio. In other words, with realized and expected volatility unusually low, high yield appears attractive on a risk/return basis.”

The Party Could End

It is difficult to pinpoint exactly when the high-yield party will end, but investors are already showing some skittishness toward junk bonds. For example, HYG's year-to-date inflows are just $148 million compared to billions for some rival investment-grade bond funds. Spreads are also an issue.

“The spread that investors are currently receiving, i.e. yield above a comparable maturity Treasury, is unusually small,” according to BlackRock. Since bond yields move down when the price of the bond goes up, this is usually a sign the bonds are getting pricey. How much? Since 1994 the average spread has been approximately 515 basis points (or 5.15 percentage points). Today the spread is around 350 bps. This is the lowest level in more than three years. Current levels are also starting to approach the lows witnessed just before the financial crisis.”

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