As Bets on High Yield ETFs Surge, Risk in Portfolios May Jump

Investors seeking safety from falling markets are piling into high-yield debt. With the odds of recession growing, experts caution that risk to investments may also be increasing. 

Investors piled into bond ETFs last year as they sought steady income and low volatility amid gyrating markets sparked by a historic series of Federal Reserve rate hikes, supply chain issues and Russia’s invasion of Ukraine.  

Fixed income funds’ inflows rose 8% to $189 billion from $175 billion in 2021, according to ETF.com data. That number is higher than the almost $481 billion that exited bond mutual funds by mid-December, according to Bloomberg data.  

At the same time the bond market endured its worst year in history, rising interest rates are creating economic headwinds that may add pressure to businesses’ ability to pay down debt. While balance sheets have yet to see a tailspin, lackluster earnings across sectors may be signaling a rough road in 2023.  

"We see defaults trending higher,” Eric Yu, credit strategist at Bank of America, told ETF.com. While “this year default rates have been extremely low,” the bank’s estimate for default rates in the next 12 months has risen to 5%. That’s higher than 2021’s rate of 3%, but it’s lower than the five-year default average of 5.6% and below the COVID-19 high of 15%.  

Still, investors have moved into riskier, lower-grade debt—also known as high-yield—despite the economic outlook. The $9.4 billion SPDR Bloomberg High Yield Bond ETF (JNK) pulled in $3.4 billion in the last six months of 2022 alone, a reversal of the $3 billion that exited the fund the year prior, according to ETF.com data. JNK recorded its largest one-day inflow since 2007 at the end of October, hauling in $980 million, according to Bloomberg data.  

Right before the Fed’s fourth-straight 75 basis point rate in early November, the iShares iBoxx High Yield Corporate Bond ETF (HYG) recorded $1.15 billion in inflows, a record for the fund. For the entire second half of 2022, HYG took in $3.8 billion, according to ETF.com data.  

Spreads for both high-yield and investment-grade bonds have also tightened in recent months.  

According to some experts, while better potential returns on high-yield bonds may be luring investors, they might turn riskier as rate hikes affect the economy. 

“For investors who have a higher risk appetite, the yields in high yield right now can look relatively attractive, certainly compared to history,” Kristy Akullian, senior iShares strategist, said to ETF.com. “We still favor higher quality debt because we're at that turning point where we are either going to see the U.S. head into a recession, or we're going to see sort of a prolonged period of slower growth.” 

Fed Chair Jerome Powell last month said the central bank’s terminal rate, the level at which the Fed is expected to stop raising interest rates, would reach 5.1%. He also said officials aren’t yet confident the 5.1% peak estimate won’t change in the months to come.    

iShares executives have instead pointed to solid returns on investment-grade bond ETFs—like the Vanguard Short-Term Corporate Bond ETF (VCSH)—which last year performed similarly to high-yield funds such as the SPDR Bloomberg Short Term High Yield Bond ETF (SJNK).  

“The case for investment-grade credit has brightened, in our view, and we raise our overweight tactically and strategically,” BlackRock executives said in their 2023 global outlook. “We think it can hold up in a recession, with companies having fortified their balance sheets by refinancing debt at lower yields.”  

Still, other experts maintain that high-yield debt, which may now yield upward of 9%, remains a viable investment opportunity given the steadiness of lower-graded companies’ balance sheets.  

“You do have a high-yield universe that has never been as high quality,” said Mark Carlson, senior investment strategist at FlexShares Exchange Traded Funds, pointing to the benefits high-yield debt poses in comparison to equity markets.  

“We really do look at high-yield debt being in between fixed income and equity,” he said. “You get a lot of the equity risk premium in high-yield but with a fraction of the volatility.” 

Contact Shubham Saharan at [email protected]