High-Yield Debt Continues its Move Higher

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In an ultra-low interest rate universe, yield-hungry fixed-income investors have been left with precious few places to put their money to work. With record low interest rates, investors are sitting on huge piles of cash that in many cases is being funneled into high-yield funds, evidenced by the huge inflows these funds have experienced over the last year. While some analysts warn that the bull-run on high-yield debt may be reaching bubble territory, this hasn’t seemed to deter investors so far, as this asset class has already posted modest gains in the first month of the year.

The Situation

In 2012 junk bonds returned over 14%, and in the last four years, provided a total return of over 105%. So far this year, junk bonds have returned about 1.3%, compared to a negative return of 0.15% on investment grade corporate debt. Corporate debt, represented among other funds by the ETF proxy iShares iBoxx $ Investment Grade Corporate Bond ETF (NYSEMKT: LQD), currently yields only 3.6%, reflecting the low central bank interest rates. 

As high-yield debt serves as an important barometer for risk appetite, some commentators believe its performance has signaled a change in sentiment towards risk assets, which bodes well for 2013. Aside from optimism over the global economic recovery and diminishing fears of a European financial meltdown, junk bond fund inflows have of course also been boosted by the low interest rate climate and the resulting chase for higher yields.

However, two factors should lead one to be cautious on high-yield debt. First of all, contrary to many investors’ perception of the bond market, junk bonds tend to be quite a volatile asset class, prone to fairly extreme drawdowns.  In 2008 for example, during the depths of the financial crisis, high-yield bonds experienced a decline of more than 32%. Secondly, junk bonds’ strong performance over the last few years may have left them in overvalued territory. Although talk of a junk bond bubble is exaggerated according to some, as junk inflows do not appear to be accompanied by excessive leverage as was the case in other recent bubbles, several fund managers have expressed their doubts as to the prospects of high-yield debt citing high valuations and fundamental factors.

ETF Options

For those investors who are looking to take on some risk and chase high-yield returns, there are several ETF options. The two most popular alternatives are SPDR Barclays High Yield Bond (NYSEMKT: JNK) fund and the iShares iBoxx $ High Yield Corporate Bond (NYSEMKT: HYG) fund. JNK currently yields around 6.7% with an expense ratio of 0.40%. Its largest holdings include Sprint Nextel and Citigroup. JNK has nearly $13 billion in assets under management. HYG is another very popular ETF choice with $16 billion in AUM. The fund yields about 6.5% with a slightly higher expense ratio of 0.50%. The fund’s largest holdings include Citigroup and Blackrock.

Bottom Line

As interest rates remain at record lows, high-yield ETF funds continue their march higher. Providing relatively high returns compared to corporate debt and certainly compared to sovereign debt, these funds do indeed appear attractive. However, caution is advised at the moment due to the asset class’ strong performance over the last few years. As such, junk bonds appear to be a risky play at the moment, although recent price action suggests that many investors remain optimistic.

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