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Summary

  • High yield bonds ETFs are starting to show signs of weakness that may mark a turning point.
  • Recent Federal Reserve comments point to the potential of a bubble in high yield bonds.
  • Pairing investment grade corporate or emerging market bonds with a similar yield may offer better long-term results.

The Federal Reserve has mapped out its target for an October deadline to exit the quantitative easing measures that have helped stimulate the stock and bond markets for the last several years. The next step that economists are avidly trying to forecast is the timeline for additional fiscal tightening that could throw a wrench in the complacent market we have become accustomed to.

In recent remarks before Congress, Federal Reserve Chair Janet Yellen opined that "maintaining interest rates at low levels for a long time can incent reach for yield and asset bubbles. We are monitoring this closely."

Well that's comforting.

Certainly one of the areas that has been highly sought out in the reach for yield are junk bonds, which have lured many conservative income investors farther down the credit spectrum than they are accustomed to. The low interest rate and below-average default environment has been a recipe for success in high yield bonds for some time now. However, we are starting to see subtle changes in the makeup of this fixed-income market that may point to waning demand and teetering growth.

A quick check of the iShares High Yield Corporate Bond ETF (NYSEARCA:HYG) shows a rollover in price that has now penetrated the 50-day moving average for the first time in nearly a year. While the decline from the highs has been relatively shallow to-date, this technical breach is something to pay attention to. This is particularly poignant when we are seeing continued strength in major domestic equity indices such as the SPDR S&P 500 ETF (NYSEARCA:SPY).

In addition, the high yield bond market is experiencing compressed yields and relatively lackluster year-to-date performance versus other fixed-income alternatives. In fact, HYG isn't even in the top half of competitive bond sectors so far in 2014.

TickerNameYTD %Yield %
CWBSPDR Barclays Convertible Securities ETF9.461.64
EMBiShares J.P. Morgan USD Emerging Markets Bond ETF8.834.31
MUBiShares National AMT-Free Muni Bond ETF6.061.9
LQDiShares iBoxx $ Investment Grade Corporate Bond ETF5.963.1
IEFiShares 7-10 Year Treasury Bond ETF5.262.5
HYGiShares iBoxx $ High Yield Corporate Bond ETF4.254.22
MBBiShares MBS ETF3.822.16
BKLNPowerShares Senior Loan Portfolio2.034.47
*Data as of 7/16/14, source: stockcharts.com

According to recent data from ETF.com, HYG has also experienced outflows of over $2 billion this year alone. That number puts it in the top 5 of all U.S.-listed ETFs in total redemptions for 2014.

It's worth noting that short-duration high yield funds such as the PIMCO 0-5 Year High Yield Bond ETF (NYSEARCA:HYS) and SPDR Short Term High Yield Corporate Bond ETF (NYSEARCA:SJNK) have actually experienced combined inflows of over $2 billion this year. That may indicate large investors are transitioning away from intermediate duration to shorter term securities in an effort to protect themselves from interest rate risk. However, the stretched valuations in the short-term junk bond space have pressed yields to their lowest levels in years. HYS currently has a 30-day SEC yield of less than 3%.

I noted a few months back the lack of motivational evidence to support further upside in this space and since that time prices have been relatively flat. The biggest problem for existing shareholders is the lack of readily available options to replace the current income stream from high yield bonds. Moving to a money market position will insulate you from credit risk, but will severely impact your portfolio cash flow. In addition, establishing a new cost basis in a different sector at heightened valuations or lower coupon may be prohibitive to achieving your goals.

Depending on your situation, you will have to analyze if the risks are worth the reward to stay in intermediate duration junk bond ETFs that could experience a consolidation or pullback on further spread widening. There is also the potential for the recent dip to become a deeper correction that presents a more opportunistic entry point for active portfolio managers.

One potential alternative to domestic high yield bonds that I have been implementing for my income clients is the iShares J.P. Morgan USD Emerging Markets Bond ETF (NYSEARCA:EMB). This ETF invests in a basket of sovereign debt from over 30 different emerging market nations with a comparable yield of 4.31%. EMB has had nearly double the performance of HYG this year, and despite unrest in areas such as Russia and Ukraine, has continued to climb steadily higher.

Another diversification alternative may be to pair high yield corporate credit with long-term investment grade corporate bonds. The Vanguard Long-Term Corporate Bond ETF (NASDAQ:VCLT) is currently paying a yield of 4.50% and would help balance or offset the lower credit quality of HYG when used in tandem. However, you should be cognizant of the fact that VCLT will be highly susceptible to interest rate fluctuations because of its longer average duration.

With some moderate adjustments, you can easily ride out a storm in high yield credit that increases your odds of capital preservation and maintaining a healthy income stream. Mapping out a disciplined investment approach and implementing it decisively will ultimately produce superior results.

Source: Why Income Investors Should Be Watching High Yield Bond ETFs

Additional disclosure: David Fabian, FMD Capital Management, and/or clients may hold positions in the ETFs and mutual funds mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell, or hold securities.