Free-falling High Yield Bond ETFs

High-yield bond ETFs continued to plummet Monday, following a price decline Friday that took major funds to levels not seen in roughly four years. Behind the weakness is an energy sector that's reeling from sliding oil prices, now at their lowest levels since 2009. Another factor weighing on high yield bonds is a growing investor awareness that there's been a lot of credit issued in recent years due to low rates, and chances are that some of these low-quality credits might default.

The two largest funds in this segment—the iShares iBoxx $ High Yield Corporate Bond (HYG | B-68) and the SPDR Barclays High Yield Bond (JNK | B-68)—were each down some 2.0% Friday, and bleeding another 1.5% Monday. From a price perspective, they are trading at levels not seen since 2011. From a total return perspective—which factors in yields and prices—these funds are back to mid-2013 levels, as the chart below shows:

Chart courtesy of StockCharts.com

Oil Fueling Drop

This latest decline is largely tied to the price of oil on energy-related companies with debt, says J.R. Rieger, managing director of fixed income at S&P Dow Jones Indices.

“The S&P 500 Energy Corporate Bond Index, tracking over $255 billion in debt, is down more than 6% year-to-date, while the overall S&P 500 Bond Index remains in positive territory,” Rieger said. “Energy bonds have been less volatile than the stock of these companies, but a 6% drop is painful for bond investors.”

“More telling is how the credit markets are viewing the cost of buying default protection on the debt of energy-related companies,” Rieger added. “The cost of buying default protection has risen by 185% since May 1, indicating the credit markets are expecting more distress in the sector over the near term.”

Gundlach’s Been Sounding Warnings

But the weakness in energy is hardly news. In fact, investors such as Jeffrey Gundlach have long been warning of the risk associated with high-yield bonds and energy. Last month, Gundlach said that unless oil prices were to recover fast, there could be widespread defaults in the energy space as these companies see lower revenues.

And he doesn't see oil prices recovering, citing extremely high inventory levels. Moreover, he says, downgrades in energy company debt from investment grade to junk could push the sector's weighting in the junk bond market to 30%.

"Junk bonds are a horrible long-term investment; you end up holding more and more of the worst-quality bonds," Gundlach said. "They should be sold on strength."

Monday, Gundlach was reinforcing his bearish outlook for high yield bonds, pointing out that the downcycle in high yield corporates could be much worse in a rising rate environment.

This latest tumble is also a good reminder of the risk/reward concept. High-yield strategies are high risk, and they typically deliver solid yields as compensation for that risk. But when things go south, high risk can mean big losses. We are now seeing this play out.

But there are those who see opportunity.

In late November, Guggenheim’s Global Chief Investment Officer Scott Minerd argued that credit markets have already priced in “a lot of bad news.” According to him, this is “an opportune time to increase allocations to bank loans and high-yield bonds.”

Reiterating Monday he is no bear on high yield bonds going forward, he said he does believe some funds have invested too much in high yield and triple-C rated bonds, prompting liquidity issues when flocks of investors tried to get out of these positions. But to Minerd, even if this problem gets worse before it gets better, the downturn in high yield corporates should be short-lived, he said, and lower prices represent a buying opportunity.

And to quote Corey Hoffstein, co-founder and chief investment strategist of Boston-based Newfound Research, “high yield can be very interesting for two reasons. First, it offers a relatively significant yield opportunity in a zero-interest-rate policy environment. Second, it can offer equitylike upside potential without necessarily taking on equitylike volatility.”

“In other words, it does not just offer income; it can offer significant capital appreciation as well,” he said.

Contact Cinthia Murphy at [email protected].