Concerns over the health of the economy coupled with a laser focus on the Federal Reserve’s rate hike timing have combined to deteriorate prices in the high yield bond market. High yield bonds, otherwise known as junk bonds, are issued by companies with below-investment grade financial status. These debt instruments carry a much higher associated coupon payment for the inherent risk that is embedded for the lender.
High yield bonds are also one of the closely watched indicators of health in the overall stock market. A deteriorating credit picture may precipitate a decline in stock prices or vice versa. Analyzing some of the diversified ETF indexes in this sector provides a clear picture as to how the fixed-income market perceives credit risk at the moment.
As an example, the iShares iBoxx $ High Yield Corporate BondETF (HYG) is the largest ETF in this space with over $13 billion in total assets. HYG tracks over 1,000 high yield fixed-income securities issued by domestic companies in almost every corner of the market. The majority of the underlying holdings carry a B or BB rating according to the top rating agencies.
HYG has a 30-day SEC yield of 6.56%, which is significantly higher than its trailing 12-month yield of 5.62%. The reason for this sudden increase in forward-looking yield has to do with the significant decline in price that junk bonds have undergone over the last two months.
The chart below shows the rapid price drop in 2015, which has extended to fresh two-year lows. In fact, HYG is down over 7% from its May high water mark and has yet to show signs that a bottom is in place.
Another confirming indicator of credit deterioration is the widening “spread” between high quality Treasury bonds and high yield corporate bonds. The chart below shows the divergence between HYG and the iShares 7-10 Year Treasury Bond ETF (IEF). A widening credit spread can be indicative of investors reducing the risk profile of their fixed-income holdings as they seek out safer areas of the bond market to hide out in until the stock market volatility subsides.
Other ETFs affected by this fundamental change in the credit markets are the SPDR Barclays High Yield Bond ETF (JNK) and PIMCO 0-5 Year High Yield Corporate Bond ETF (HYS). The shorter duration of HYS has helped mitigate the impact of the overall decline, yet the fund still shows a similar concerning price trend as the intermediate-term indexes in this sector.
Moves of this nature have generally coincided with large outflows from these funds as investors flee to cash or other opportunities in an effort to shelter capital. Nevertheless, data from ETF.com paints a relatively unconcerned picture. HYG has seen $322 million in net outflows on a year-to-date basis, while JNK has accumulated $295 million in new money. On the whole, that represents very little net change for either fund. Neither one of these ETFs has shown a pickup in large selling in recent weeks as well.
The Bottom Line
The price trend in high yield bonds may be concerning for those who purchased in the first half of 2015, only to watch their capital deteriorate on the way down. Rather than take their cue from the solid economic and labor data, indexes such as HYG are reacting to the correction in stocks alongside an uncertain future for interest rates.
However, this sell off may be looked at as an opportunity for investors that believe a turnaround in stocks is on the horizon. The larger than average spread to Treasuries makes this sector an interesting one to watch from a value perspective.
Lastly, it’s worth noting that this widening credit spread will impact other credit sensitive areas of the markets such as mortgage REITs, bank loans, and master limited partnerships. Anything with a higher than average yield has likely seen compression in prices as a result of this current environment.