Beware The Junk Bond ETF Boom

April 24, 2012

The problem with this analysis is that junk bond and leveraged loan default rates are almost certainly artificially low, reflecting forbearance by bankers. The game of “extend and pretend” is itself prompted by regulators. Until and unless economic growth picks up, however, allowing highly geared issuers to grow out of their debt burdens, default rates are almost certain to rise.

All that’s going on, in fact, is a ballooning “carry” trade, temporarily under the control of the Fed. Like all carry trades, you clip coupons for a while until, one day, you wake up to a 20%, 30% loss, or worse. A reported recent loosening of covenants on new loans and high-yield bonds is a warning sign that the quality of junk deals, to which the market-cap-weighted indices underlying high-yield ETFs are largely indifferent, is deteriorating.

Investors in junk bonds via ETFs may also be forgetting that these funds can become illiquid at the drop of a hat.

In late-2008 the junk bond market became largely untradeable and ETFs’ prices diverged wildly from their stated NAV, a reminder that entry/exit to these funds at an acceptable price can’t be taken for granted.

In recent weeks the premium/discount chart has looked more quiescent. Both JNK and HYG have traded at a slight premium, reflecting steady inflows. But the volume of cash invested in these two funds is now twenty times higher than in 2008. That, in turn, raises the threat of a more dramatic dislocation than four years ago if investors head for the exits en masse. ETFs, of course, promise instantaneous liquidity.

HYG and JNK have done very well for their creators, iShares and State Street. For investors, though, there are warning signs of a top in the junk bond ETF boom.

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