High-Yield Bond ETFs Getting Junkier?

Includes: HYG, PHB
by: Tom Lydon

Junk bonds have been attractive to investors for their high yields, the reward that comes with investing in companies with speculative grade debt. However, the near future is beginning to get muddled for junk bond exchange traded fund investors as the Presidential election is over and bigger problems loom.

A divided Congress could have big implications in the months ahead for investors in a broad swath of assets, from stocks and bonds to the dollar, say financial advisers and market strategists. The unknown in Washington is a huge part of the equation, with evidence of another recession surfacing and mediocre corporate earnings on the table.

"Despite the favorable liquidity conditions and the demand for yield, we expect to see U.S. high yield names begin to underperform investment grade credit and U.S. [Treasurys] as we head into 2013," Thomas Tzitzouris, fixed income strategist at Strategas, said in a recent analysis of the group.

High-yield bonds and ETFs are in danger now as economic uncertainty rules the stock market.

"With the U.S. likely moving towards a recession in the first half of 2013 [the fiscal cliff shock], and top line growth and earnings margins now both seemingly heading lower, it seems that U.S. corporate sector spreads may be about to begin a move higher in the next few quarters," he said.

The higher spreads between junk bonds and safer tools point to a higher level of corporate default risk, as business conditions are unfavorable and the tax climate turns ugly for any businesses, reports Jeff Cox for CNBC.

PowerShares Fundamental High Yield Corporate Bond ETF (NYSEARCA:PHB) has a yield of 5.11%, beating out the S&P 500 dividend yield. Over the past three years, the fund has fared well, reports Selena Maranjian for The Motley Fool. The iShares iBoxx High Yield Corporate Bond Fund (NYSEARCA:HYG) is down 1.2% since September. The fund has lost $219 million in outflows this week. HYG yields 6.72%.

High-yield bonds in the U.S. are losing 0.14 % this month after posting 12.9 % returns this year through October, according to Bank of America Merrill Lynch index data, reports Bloomberg BusinessWeek.

"The ease with which investors can enter and exit ETF investments creates new and risky dynamics in the speculative-grade market with the potential flow of 'hot money.' Speculative-grade companies have a higher default risk than investment-grade companies. Therefore, when the credit cycle turns against investors, losses from defaults can quickly outstrip the additional interest payments that high-yield investors receive," S&P credit analysts said in a Bloomberg BusinessWeek report.

PowerShares Fundamental High Yield Corporate Bond ETF

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Full disclosure: Tom Lydon's clients own HYG.

Tisha Guerrero contributed to this article.

Disclosure: I am long HYG. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.