A Red Flag For High Yield Bond ETFs

This has been a good year for high-yield bond ETFs, and in the near term, the outlook for defaults is also positive.

But there's the issue of valuations—they are looking high and could be pointing to a top.   

That's the view of Guggenheim's analyst team led by Scott Minerd—a firm known for its fixed-income expertise. In its quarterly report, the team said that high-yield credits have been nothing short of "impressive" in terms of performance this year, but "valuations suggest caution going forward." The firm's call? Sell on new highs, and buy on lows.

Sell Into Strength, But On Weakness

"Prices have risen for high-yield bonds and bank loans, and we are concerned about rising levels of leverage, ongoing troubles in the banking sector, and uncertainty surrounding upcoming political events," Guggenheim said. "In this environment, we will likely be selling into strength and buying on weakness." 

According to Guggenheim data, junk bond prices are averaging 94.9% of par, "the highest since July 2014." 

"Over the long term, our fundamental outlook for below-investment-grade credit reflects a concerning trend in leverage: By either net or gross measures, the high-yield market-leverage multiple has surpassed the historical peak," Guggenheim said. "The implication is that existing high-yield issuers who access capital markets will be marketing leverage multiples that make lenders fairly uncomfortable."

Popular & Performing

Jumping into high-yield bond ETFs has been a popular trade this year. Consider that the two largest ETFs in this segment, the iShares iBoxx $ High Yield Corporate Bond ETF (HYG) and the SPDR Barclays High Yield Bond ETF (JNK), have now delivered more than 12% in year-to-date returns, and have climbed to new all-time highs, outperforming the broad U.S. stock market: 

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As these ETFs rallied, investors have poured more than $3.6 billion in combined net assets into these two ETFs alone. Today HYG, the oldest of the two, boasts nearly $18 billion in total assets. The fund's current 30-day yield is 5.35%.

JNK, meanwhile, is offering a 30-day yield of 5.79% and has total assets of $11.85 billion.

A Suitable Alternative For Yield Seekers?

Yield-seeking investors may find a more attractive alternative in bank loans this quarter, although the segment isn't a bargain either. As Guggenheim puts it, "As a lower-beta credit play, we believe the bank loan market currently offers better value than high-yield bonds."

In general, one of the appeals of bank loans is that they sit higher in the corporate structure, and they are floating-rate securities, which means their coupons adjust with changes in interest rates—something that offers income without much duration risk at a time when everyone is concerned about duration exposure in a rising-rate environment.

So far this year, some of the biggest ETFs in this segment, such as the PowerShares Senior Loan Portfolio (BKLN) and the SPDR Blackstone / GSO Senior Loan ETF (SRLN), have both delivered positive returns, but nowhere near the upside run seen in junk bonds. 

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They've also gathered assets. BKLN has raked in almost $2 billion year-to-date in fresh net creations, jumping to a $6.1 billion in total assets. SRLN, which has taken in more than $100 million so far in 2016, is nearing $1 billion in total assets.

"The fundamental picture for the bank loan market is much stronger. Earnings growth remains steady, while interest coverage looks strong. Valuations in the loan market also appear stretched, however, with 44% of the secondary loan market currently trading above par," Guggenheim said in the report.

Better Risk-Adjusted Returns

"Although high-yield corporate bonds have delivered more than twice the total return versus bank loans, the bank loan market has delivered better risk-adjusted returns as a result of limited volatility," the report added.

"As the lower beta credit play, we believe bank loans will deliver strong returns through the fourth quarter as well against a backdrop of political uncertainty," according to the report.

In the ETF space, Guggenheim is the provider behind 78 different ETFs, 22 of which are fixed-income strategies. The firm manages some $29.4 billion in ETF assets.  

Contact Cinthia Murphy at [email protected]