High-Yield Bond ETFs: What to Do if the Party’s Over

 |  Includes: HYG, JNK
by: Tom Lydon

The high-yield market that has been so loved by investors may be changing its tune sometime soon. If the analysts are correct, here’s how to can protect yourself if your high-yield ETFs begin to suffer.

The troubles of 2008 ultimately led to outperformance of high-yield bonds and their related ETFs. The BarCap U.S. Corporate High Yield Index is up 55% year-top-date. John Jannrone for The Wall Street Journal reports a downside: the high-yield boom has generated premiums on ETFs that may not last.

Over the past year, inflows into high-yield ETFs have been non-stop. Many funds have doubled or tripled in size.

What could trigger any outflows?

  • As ETFs mature, marginal investor demand will likely decline, especially if the high-yield market falters. Just as investment banks buy bonds to create units, they sell bonds after redeeming units. If the bond market becomes illiquid, trading costs could jump. That could pressure ETF prices down to discounts before investment banks are willing to purchase and redeem units.
  • High-yield ETFs also struggle to keep up with benchmark bond indexes. That’s because they sometimes trade bonds that are dropped or added to indexes, incurring transaction costs. Some index components that are hard to find may be left out of ETFs.
  • High-yield ETFs offer better liquidity than investors likely can find elsewhere. When high-yield bond markets came to a standstill last year, the ETF market remained active and deep.

All trends eventually wind down. That’s why you need not only an entry strategy, but an exit one, as well. We use the 200-day moving average and an 8% stop loss: when a position drops below the 200-day or 8% off the recent high, it’s a sell signal.

  • iShares iBoxx High Yield Corporate Bond (NYSEArca: HYG): up 27.7% year-to-date

  • SPDR Barclays Capital HIgh Yield Junk Bond (NYSEArca: JNK): up 37.1% year-to-date