Junk Bond ETFs: Another Big Short
Sometimes the market makes it too easy. Check this out:
BOSTON (MarketWatch) -- Investors fed up with U.S. stocks' negative returns over the past decade and paltry rates in today's fixed-income markets are piling into exchange-traded funds that invest in high-yield corporate bonds.
"Where else can you get an 8% yield? The S&P 500 (MARKET:SPX) is flat over the last dozen years," said Matt Hougan, head of ETF analytics at IndexUniverse. "I'm not surprised people are looking elsewhere on the capital spectrum."
Still, investors need to be wary of the higher risk in "junk" bonds, which can manifest itself in big price swings relative to other categories of bonds. Structurally, Hougan noted the high-yield bond ETFs can trade at "significant premiums" to their net asset values. ETFs following less-liquid markets can see wider trading spreads.
Two high-yield ETFs with large asset bases -- iShares iBoxx $ High Yield Corporate Bond Fund (CONSOLIDATED:HYG) and SPDR Barclays Capital High Yield Bond ETF (CONSOLIDATED:JNK) -- both saw year-to-date inflows of more than $1.2 billion through July, according to data from the National Stock Exchange. More cash likely moved in the door this month amid a surge in bond issuance from corporate America.
The high-yield bond ETFs rallied in 2009 on easing economic and credit concerns, but are essentially treading water so far this year. The SPDR Barclays Capital High Yield Bond ETF gained 37.7% in 2009, according to investment researcher Morningstar Inc., as worries over defaults and bankruptcies eased. The fund lost 24.7% in 2008 as the credit storm raged. Both ETFs are currently yielding around 8%.
Hunting for income
With six-month certificate of deposit rates averaging less than 1% nationally according to BankRate.com, it's no wonder many individuals are looking well beyond traditional savings accounts for income. The Federal Reserve has indicated it intends to keep short-term rates near zero to help stimulate the troubled economy and job market.
"The measly yields offered by the vast majority of fixed-income securities have forced investors to step up their hunt for current returns," said Michael Johnston, senior analyst at ETF Database. "For many, that search has led to junk bonds."
Although low rates have punished savers and investors approaching or in retirement who rely on income, they need to consider the risks of bond funds that are offering tempting yields, such those that invest in paper from companies that have lower credit ratings.
Investing in high-yield corporate bonds is "similar to investing in the equities of companies with highly leveraged balance sheets," said Morningstar ETF analyst Timothy Strauts.
In his latest report on SPDR Barclays Capital High Yield Bond, he said the ETF "should be viewed as a satellite holding, and a risky one at that." The fund takes an indexed approach with 166 holdings. The expense ratio is 0.4%, compared with 0.5% for iBoxx $ High Yield Corporate Bond Fund.
Some investors may be drawn to junk-bond ETFs because their yields are much higher than those offered by Treasury funds.
"With increased leverage comes the increased probability of default and bankruptcy," says Morningstar's Strauts. "In the grand scheme of things, risk equals return, and the 'high' yield of these bonds is designed to compensate investors for this risk."
Recently, there are signs volatility in equity markets "has taken its toll on retail investor enthusiasm about high-yield bonds," said Oleg Melentyev, credit strategist at Banc of America Securities LLC, in an Aug. 9 research note.
The strategist said inflows into the fund sector slowed to $50 million in the latest week, a "marked departure" from intakes of at least $500 million seen in each of the previous five weeks.
The volume of U.S. junk bonds has topped $155 billion this year and is on pace to break 2009's record, The Wall Street Journal reported earlier this month.
I used to be a junk bond analyst and learned from that experience that the math generally doesn't work. Think about it. If you buy a junk bond at par and its price rises because the issuing company is doing well, they'll call the bonds away from you. So your upside is limited to the coupon plus a modest take-out premium. But your downside risk if the company runs into trouble -- as a big percentage of junk issuers do -- is much higher, frequently 50% or more. Even in good times these aren't attractive odds.
The default rate for junk bond issuers has been very low lately. This is always the case when money is easy, because even weak companies are able to avoid default by refinancing their loans. But when the economy turns down or interest rates rise you discover, as Warren Buffett likes to say, who's been swimming naked. Typically the junk market has a lot of skinny-dippers.
The whole sad story of junk bond ETFs is encapsulated in a quote early in the article: "Where else can you get an 8% yield?" It illustrates a point that tends to be missed by small investors who are induced by Wall Street to pile into risky instruments, which is that yield and return are two different things. A bond can yield 10% but return -10% if its price drops by 20%. So buying the highest yielding security is a fairly sure way to get a positive yield and a negative total return. The current generation of yield chasers will learn this lesson in 2011.
Their tragedy is an opportunity for the rest of us, because junk-bond ETFs can be shorted like stocks. And as if they weren't leveraged enough, these things have options! So short the ETFs, write covered puts on them to lower your cost basis, and wait for the market to show signs of cracking. Then close the covered puts and let your shorts ride. This is as close to a no-brainer as we're going to get.