The last six months have seen dramatic inflows into US-listed junk bond ETFs. iShares’ iBoxx $ High Yield Corporate Bond ETF (NYSE Arca: HYG) and State Street’s SPDR Barclays Capital High Yield Bond ETF (NYSE Arca: JNK) have each added around US$6 billion in assets, with JNK doubling in size since October.
In a worrying divergence between volume and price, the accelerating inflows are not being reflected in the funds’ performance. For example, HYG’s Monday closing level, 90.13, is down a couple of percentage points from a year ago, April 2011, which marked this junk bond ETF’s post-crisis price peak to date.
It’s not price performance that investors are primarily focused on, of course—it’s income. Both HYG and JNK advertise 7%-plus yields to maturity, an eye-watering figure in an era where the vice-chairman of the Federal Reserve has been talking openly about three more years of zero official rates.
Forcing investors to chase yield in an environment of so-called “financial repression” is one of the Fed’s (unspoken) objectives. Propping up the prices of low-quality bonds and, indirectly, those of equities, is one way of bailing out the banking system, or at least of preventing it from getting worse. There’s no shortage of investment commentators suggesting you take those bond coupons while you can. For example, here’s a recent article from Peter Ehret, head of high yield at Invesco, suggesting you react in just the way the Fed is prompting you to do.
“High yield investing is one way to potentially escape being squeezed by financial repression,” says Ehret, adding that “high yield bonds have had very low default rates over the past two years and default rates are expected to remain low through 2013. According to JP Morgan research, default rates are forecasted to be 1.5% for 2012 and 2% for 2013, which is well below the historical 25-year average of 4.2%.”
The problem with this analysis is that junk bond and leveraged loan default rates are almost certainly artificially low, reflecting forbearance by bankers. The game of “extend and pretend” is itself prompted by regulators. Until and unless economic growth picks up, however, allowing highly geared issuers to grow out of their debt burdens, default rates are almost certain to rise.
All that’s going on, in fact, is a ballooning “carry” trade, temporarily under the control of the Fed. Like all carry trades, you clip coupons for a while until, one day, you wake up to a 20%, 30% loss, or worse. A reported recent loosening of covenants on new loans and high-yield bonds is a warning sign that the quality of junk deals, to which the market-cap-weighted indices underlying high-yield ETFs are largely indifferent, is deteriorating.
Investors in junk bonds via ETFs may also be forgetting that these funds can become illiquid at the drop of a hat.
In late-2008 the junk bond market became largely untradeable and ETFs’ prices diverged wildly from their stated NAV, a reminder that entry/exit to these funds at an acceptable price can’t be taken for granted.
In recent weeks the premium/discount chart has looked more quiescent. Both JNK and HYG have traded at a slight premium, reflecting steady inflows. But the volume of cash invested in these two funds is now twenty times higher than in 2008. That, in turn, raises the threat of a more dramatic dislocation than four years ago if investors head for the exits en masse. ETFs, of course, promise instantaneous liquidity.
HYG and JNK have done very well for their creators, iShares and State Street. For investors, though, there are warning signs of a top in the junk bond ETF boom.