Junk Bond ETFs Hit By Cheap Oil

Not everyone’s a winner when oil prices collapse.

If you’ve been reading headlines lately, you’ve probably caught a note of panic among followers of high-yield bonds, capped by this lovely headline at Business Insider yesterday:

“Let’s Take A Closer Look At These Energy Junk Bonds Everyone's Freaking Out About.”

I give the headline points for clarity, but demerits for economy. Still, there is a bit of a panic going on in the junk bond world, and for good reason. Energy companies have traditionally been big users of the debt markets, and while of course huge diversified companies don’t often end up in the junk bond funds, plenty of smaller, more speculative companies do.

In many ways, the energy sector, like telecommunications, is the poster child for why the junk bond market exists in the first place. Companies like Antero Resources use the bond markets to raise cash to go drill new wells, just like small telcos use the bond market to raise cash to string new fiber. It’s classic infrastructure investment.

Because of that, those two sectors are big factors in most junk bond indexes, and while nothing all that special is hitting the telcos, we all know what’s been going on with oil.

Where Are The Risks?

So how does this impact junk bond ETFs? The iShares iBoxx $ High Yield Corporate Bond ETF (HYG | B-66), for instance, has roughly a 15 percent exposure to energy. Our Analyst Pick SPDR Barclays High Yield Bond ETF (JNK | B-68) has more than 17 percent in energy. And since both ETFs follow indexes that eventually try and mirror the market for available debt, their exposure to energy is likely to increase, as this year was the largest in a long time for energy junk-bond issuance. Some analysts have it as high as 19 percent of all new paper that’s hit the street in 2014.

As investors get nervous about the prospects for these less-than-investment-grade energy companies, they are, as you expect, demanding higher and higher yields for their money, which means prices have come down. That’s put a real drag on performance recently, with both funds giving back most of their yield for the year due to falling prices:

I added a wrinkle to the above chart: the PowerShares Senior Loan ETF (BKLN | B). BKLN isn’t a junk bond fund, but many investors have flocked to it for the same reason they buy junk bonds—yield.

BKLN holds floating-rate notes that are generally below investment grade. They have similar default characteristics to junk bonds, but can actually see spikes in defaults from rising rates, so it’s worth being extra weary. Still, the comparison is apt: HYG is currently advertising a yield to maturity of 5.89 percent.

Energy-heavy JNK is showing 6.69 percent, and BKLN is in the ballpark at 4.82 percent. Yield to maturity is the rate of return anticipated on a bond if held until the end of its lifetime.

Is One Better Than The Others?

That lower yield in BKLN is partially explained by its shorter-term nature (the average reset for the loans it holds is generally a month, whereas generally the bond funds hold paper that matures in 5-6 years). But some of it can also be explained by the sector breakdown—BKLN has just 5 percent of its portfolio exposed to the energy markets.

Does this make BKLN a buy and the others a sell? Not necessarily. The point of investing in junk bonds is, after all, to take a little speculative risk in return for the higher yields. Oil exploration and production company debt is currently yielding in the range of 10 percent—that’s a pretty fat coupon check to get every quarter.

The question is, how much risk are you really taking? There’s little question there will be some defaults next year, but how many is just a guess. Some pundits, like Martin Fridson of Lehmann Livian Fridson, is predicting a huge increase in overall junk defaults—but not for several years. Others are predicting a more modest bump from the current levels of around 1.9 percent a year to 2.5 percent.

If that’s the case, an indexed approach that spreads that risk out, but still captures those higher yields, may be just what the doctor ordered. That’s certainly what the hedge fund community is counting on—it’s been the big buyers of this year’s junk bond offerings. ETF investors seem pretty happy to stay the course as well—HYG and JNK have pulled in almost $3 billion in new assets so far in the fourth quarter.

At the time this article was written, the author held no positions in the securities mentioned. You can reach Dave Nadig at [email protected], or on Twitter @DaveNadig.