Buying Opportunity In Junk Bond ETFs

The financial market turmoil of the past week has had many victims. From stocks to commodities, there haven't been many areas immune to the recent selling.

However, the bond market has seen real resilience. U.S. Treasurys—considered the ultimate safe haven by many—rallied solidly during the past few weeks, while U.S. investment-grade corporate bonds held steady in that period.

While the higher-quality areas of the bond market have weathered the latest bout of risk aversion, riskier bonds haven't fared so well. The iShares iBoxx $ High Yield Corporate Bond ETF (HYG | B-64), the giant in the space, having $12 billion in assets, hit its lowest price since 2011 earlier this week.

The price decline in high-yield bond funds lifted the yield for HYG and similar ETFs to their highest levels since 2012. Based on current prices, HYG has a juicy yield-to-maturity of 7 percent. Is now the time to buy, or is there more downside in store?

Junk Bond Yields

Source: Barclays

Tied To The Economy

In general, high-yield corporate bonds―also known colloquially as junk bonds―perform poorly when concerns about the economy intensify. Issued by companies on the riskier end of the spectrum, the default rate for these bonds is already higher than investment-grade bonds, and that rate naturally increases during tough economic times.

In recent years as the economy has recovered, defaults have been rare. According to Moody's, the U.S. speculative-grade default rate during 2014 hit a six-year low of 1.7 percent. That pressured the spread between junk bonds and safe-haven 10-year Treasurys to as low as 2.2 percent in 2014, based on data from Barclays.

Earlier this week, the spread reached 5.5 percent, the loftiest level in three years as economic fears intensified, prompting traders to dump their positions. Given the ferocious selling this week, traders are clearly betting that defaults will pick soon.

High-Yield Treasury Spread

Source: Barclays

That said, a quick glance at the charts reveals that these bonds have been selling off for some time now, and in fact, this week's decline was simply a continuation of a downtrend that began a year ago.

The Oil Factor

Indeed, the peak of the high-yield market was hit in June 2014. That's the same month that crude oil prices topped out before they began their dramatic descent to 6 ½-year lows below $40.

It's no coincidence that high-yield bonds and crude peaked at the same time. Junk bond issuances were a major source of capital for energy companies to fund their operations during the drilling boom of the past several years. While interest rates were at record lows, these firms loaded up on cheap junk debt to take advantage of the shale oil boom and triple-digit oil prices.

Once oil prices began, the fortunes for these companies turned on a dime. Now, many of the smaller shale players are facing bankruptcy if oil prices stay at these depressed levels.

High-yield ETFs hold a substantial portion of their portfolio in debt issuances from the energy sector. For HYG, such debt represents 12.8 percent of its portfolio. Companies in the "basic industry" sector, which include a lot of downtrodden coal producers, represent 5.8 percent of the fund's holdings.

Given the high exposure to energy and basic material firms, junk bond defaults are sure to pick up. Moody's estimates that the default rate could reach as high as 3.2 percent in 2016.

Still, even that uptick would leave the default rate below the long-term average of 4.3 percent.

Potential Buying Opportunity
While there are reasons to approach high-yield ETFs with caution, for investors with a long-term horizon, there could be value in the space following this year's decline.

For one, the high yields provided by these funds provide some buffer against capital depreciation. To be sure, if global woes unexpectedly tip the U.S. into a recession, defaults will rise significantly and junk bond prices will tumble, overwhelming the gains from interest payments.

However, barring a full-blown recession, the downside in bond prices may not be so severe.

In fact, since HYG's inception, the ETF has delivered a negative total return in only one of the past eight years―in 2008. That year, of course, featured the worst financial crisis and economic downturn in modern history. Even then, the 17.6 percent loss in HYG was more than made up for in 2009, when the fund returned 28.6 percent.

Even this year, HYG is actually outperforming its investment-grade counterpart, the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD | A-77), which has a year-to-date total return loss of 1.8 percent compared with a loss of 1.5 percent for HYG. It's also outperforming the iShares 20+ Year Treasury Bond ETF (TLT | A-85), which has returned a loss of 1.7 percent.

Of course, each high-yield bond fund will perform differently, depending on its holdings. HYG isn't even the best performer of the year. That title goes to the Market Vectors Fallen Angel High Yield Bond ETF (ANGL | C-49) with a total return of 4.4 percent since the start of the year.

On the flip side is the ProShares High Yield - Interest Rate Hedged ETF (HYHG | C-37), which has underperformed with a -3.8 percent return amid this year's decline in rates.

YTD Total Returns For HYG, LQD, ANGL, HYHG

The Bottom Line

While high-yield bond ETFs come with risks, they offer a compelling opportunity following this year's downdraft. The biggest risk facing the group is the potential for an economic downturn. While that's currently considered a low probability by most economists, it's worth noting that junk bonds tend to perform most poorly during recessions.

Another area of concern for high-yield investors is credit risk.

Even without a recession, corporate default rates could rise (particularly in the energy sector), prompting bond prices to drop and credit spreads to climb. Spreads against Treasurys already widened from 2.2 to 5.5 percent during the past year. There's certainly the potential for them to widen more. In 2011, they briefly traded at more than 8 percent, while in the early 2000s they briefly traded at more than 10 percent.

The last consideration is something all bond investors must contend with: interest-rate risk. If the Federal Reserve hikes rates—as widely expected later this year or early in 2016—yields could rise, pressuring bond prices and returns.

There are a number of ETFs out there such as HYHG that attempt to mitigate this risk.

Contact Sumit Roy at [email protected].