A System For Facing Perils Of High Yield

May 28, 2015

This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today’s article features Steve Blumenthal, chairman and chief executive officer of King of Prussia (greater Philadelphia area), Pennsylvania-based CMG Capital Management.

 

The high-yield bond market has been one of the great recovery stories since the scariest days of the financial crisis. It could become scary again when the Federal Reserve begins raising rates and investors should think through the coming challenges.

 

Looking back, junk bonds became one of the emblems of that crisis, with prices of the index that underlies the iShares iBoxx $ High Yield Corporate Bond ETF (HYG | B-64) dropping 31.77 percent in just six months from June 1 to Dec. 1, 2008, according to data from Morningstar.

 

Not many people had the guts to buy at the bottom, but those who did have more than doubled their money—an annualized return of 14.06 percent from Dec. 1, 2008 through April 2015. This rivals the S&P 500 Index’s annualized total return of 16.55 percent over the same period.

 

That said, as I noted, today junk bonds may be facing some powerful head winds, but the ETF market offers investors some interesting choices for managing these head winds as they morph into real risks. 

 

 

Part of the problem is the extent to which high yield has become popular since the dark days of the financial crisis. Underwhelmed by the low yields on government and investment-grade corporate bonds, investors have poured money into high-yield mutual funds and ETFs.

 

Here are a few facts that should give investors pause:

  1. The U.S. junk bond market has grown from $1 trillion to $2 trillion in just the last five years.
  2. In 2006 and 2007, corporations issued $700 billion in debt.
  3. In 2013 and 2014, corporations issued $1.1 trillion in debt. That’s an increase of more than 50 percent over levels seven years earlier. Crucially, however, about 28 percent of debt issued in the first period was “B” rated, while in the past two years, 71 percent of the debt issued is “B” rated.
  4. Worse, in 2006 and 2007, less than 20 percent of the debt issued was covenant light. Now more than 60 percent issued is covenant-light. That basically means investors in the newer debt issues with few covenants will have little protection when things go wrong.

 

With so much capital available to be put to work, companies that would not normally attract funding through the securities markets are finding it easy to issue bonds. More to the point, they’re able to do so with terms that are advantageous to them and far less favorable to investors. That means lower yields, fewer safeguards and elevated risks.

 

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