Following the unprecedented economic turmoil, market volatility, and government intervention of the last two years, many investors felt that the painful lessons from the downturn had yielded a “new normal.” The term, coined by PIMCO executive Mohamed El-Erian, has seen its scope expand to describe an era where risk aversion runs high, caution trumps emotion and the “castle in the air” approach to investing has been left by the wayside in favor of a more practical “firm foundation” methodology.
But certain areas of the financial markets are becoming reminiscent of the old normal. “In the high-yield credit markets, it is time to party like it’s 2006,” writes Peter Lattman. After running from high risk debt issues for the last two years, investors are now flocking to junk bonds, and many companies are raising more capital than planned from oversubscribed debt offerings. According to Thomson Reuters, $11.7 billion in high-yield debt was raised last week, an all-time record (the previous mark was set in November 2007).
The boom in junk bond markets has some concerned that investors are ignoring risk in the chase for yield. Also disturbing is the ultimate use of the cash being raised. Issuers aren’t facing an abundance of positive ROI operational opportunities, but rather are looking to improve balance sheets, push back existing debt, and even make dividends to shareholders. Beyond the obvious default risk inherent in junk bonds, some see additional reasons to be wary when investing in high yield debt. “It’s good that fewer companies are failing,” writes Agnes Crane. “But high debt prices don’t leave room for 2010’s biggest financial market risk: the potential fallout when central banks withdraw from markets.”
The sudden popularity of high yield debt is easy enough to explain. When equity markets bottomed in March, attractively-priced stocks were abundant and bargain hunters had a field day scooping up undervalued securities. But following a significant run-up that has seen many benchmarks gain more than 50% from bear market lows, equity bargains are now hard to come by. Meanwhile, a still fragile recovery has forced the government’s hand on many economic policies, and the Federal Reserve has indicated that it will keep interest rates near zero for the foreseeable future. With unattractive yields on Treasuries, investors have become willing to take on more risk to gain fixed income returns.
According to the Wall Street Journal, the average gap between yields on high-yield bonds and U.S. Treasuries is about 6%, down from 6.4% at the start of 2010. At the height of the credit bubble in early 2007, the spread was less than 3%, and had increased to about 22% at the peak of the financial crisis in December 2008. With spreads still more than twice the pre credit bubble level, a collapse of the market isn’t imminent. But some experts think investors are becoming blind to risk once again, essentially writing off a repeat of a worst case scenario. “They’re all yield junkies,” said Lazard Freres vice chairman Barry Ridings recently. “Did everyone forget that 2008 happened?”
Junk Bond ETF Options
Junk bond ETFs delivered solid returns in 2009, and also swelled in size as investors embraced exchange-traded products as an efficient way to access this corner of the fixed income market. More than $4.4 billion flowed into the three junk bond ETFs last year.
For investors willing to overlook the significant risk characteristics of high yield bonds, there are several ETF options. Likewise, investors looking to short junk bonds can make that play in a number of different ways ((for more head-to-head ETF comparisons, sign up for our free ETF newsletter):
- iShares iBoxx $ High Yield Corporate Bond Fund (HYG): This ETF offers impressive depth of exposure to the junk bond market, holding nearly 300 individual securities. HYG also diversifies its exposure across all sectors of the economy, investing in debt from oil and gas companies, financial institutions, and technology firms, among others. HYG maintains a fund credit rating from S&P of B- and charges expenses of 0.50%.
- SPDR Barclays High Yield Bond ETF (JNK): Based on the Barclays Capital High Yield Very Liquid Index, this ETF invests in more than 150 speculative bonds. JNK was recently offering a 30-Day SEC Yield of almost 8.6%, 40 basis points more than HYG.
- PowerShares High Yield Corporate Bond Portfolio (PHB): This ETF is the smallest of the three junk bond ETFs, but still has a market cap of about $200 million and average daily volume of about 100,000 shares. This ETF has about 50 holdings and tracks an equal-weighted index, thereby limiting exposure to any one debt issue or issuer.
Disclosure: Author holds a long position in JNK.