Beware The Junk Bond ETF Boom

April 24, 2012

High-yield bond ETF buyers are making an increasingly risky bet.

 

[This blog originally appeared on our sister site, IndexUniverse.eu.]

 

The last six months have seen dramatic inflows into US-listed junk bond ETFs. iShares’ iBoxx $ High Yield Corporate Bond ETF (NYSE Arca: HYG) and State Street’s SPDR Barclays Capital High Yield Bond ETF (NYSE Arca: JNK) have each added around US$6 billion in assets, with JNK doubling in size since October.

In a worrying divergence between volume and price, the accelerating inflows are not being reflected at all in the funds’ performance. For example, HYG’s Monday closing level, 90.13, is down a couple of percentage points from a year ago, April 2011, which marked this junk bond ETF’s post-crisis price peak to date.

It’s not price performance that investors are primarily focused on, of course—it’s income. Both HYG and JNK pay 7%-plus yields to maturity, an eye-watering figure in an era where the vice-chairman of the Federal Reserve has been talking openly about three more years of zero official rates.

Forcing investors to chase yield in an environment of so-called “financial repression” is one of the Fed’s (unspoken) objectives. Propping up the prices of low-quality bonds and, indirectly, those of equities, is one way of bailing out the banking system, or at least of preventing it from getting worse. There’s no shortage of investment commentators suggesting you take those bond coupons while you can. For example, here’s a recent article from Peter Ehret, head of high yield at Invesco, suggesting you react in just the way the Fed is prompting you to do.

“High yield investing is one way to potentially escape being squeezed by financial repression,” says Ehret, adding that “high yield bonds have had very low default rates over the past two years and default rates are expected to remain low through 2013. According to JP Morgan research, default rates are forecasted to be 1.5% for 2012 and 2% for 2013, which is well below the historical 25-year average of 4.2%.”

 

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