[This blog originally appeared on our sister site,
IndexUniverse.eu.]
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.
It's not price performance that investors are primarily focused on,
of course-it's income. Both HYG and JNK pay 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.
Don't forget to check IndexUniverse.com's ETF Data
section.
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