Are Junk Bonds Starting to Stink?

11/14/2017 10:37 am EST

Focus: INCOME

Mike Larson

Editor, High Yield Investing

This is nothing more than a credit market “hiccup.” It does not look like a major negative turn in the credit cycle. So, look into buying higher-yielding ETFs if you need to boost the income your portfolio throws off writes Mike Larson, senior analyst at Weiss Ratings.

Are junk bonds starting to stink? That’s what it looks ... er ... smells like!

Take a look at this chart of the SPDR Bloomberg Barclays High Yield Bond ETF (JNK, Rated “B-”), one of two benchmark ETFs that that track the higher-risk, higher-yielding, low-credit-quality corner of the bond market:

chart

You can see that it stumbled hard in the past couple of weeks, falling to its lowest level since March. It’s still up more than 5% on the year once you factor in capital gains plus the generous 5.7% yield. But that’s a noteworthy give up for the ETF with $13.1 billion in assets.

We’re seeing similar declines in the $19.3 billion iShares iBoxx $ High Yield Corporate Bond ETF (HYG, Rated “B-”), as well as specialty junk bond ETFs that purport to invest in “safer” higher-risk bonds (if there is such a thing!).

The JPMorgan Disciplined High Yield ETF (JPHY, Rated “D+”) takes a factor-based approach rather than an index-focused one in order to identify bonds with better liquidity and quality. But it’s still down 0.68% in the last month.

Meanwhile, the IQ S&P High Yield Low Volatility Bond ETF (HYLV, Unrated) that purports to focus on securities with lower-volatility than the overall junk bond market is nevertheless off 0.74%.

What’s going on?

First, some investors are worried that the bond purchase tapering we’re seeing from the U.S. Federal Reserve and its counterparts overseas could reduce liquidity and widen risk spreads in the market. In other words, the difference in yield between risk-free Treasuries and riskier junk bonds will widen – driving down the price of junk bonds and the ETFs that own them.

Second, a handful of junk bond sales foundered in the past several days as a few heavy borrowers reported disappointing quarterly results. Government pushback against the proposed AT&T (T, Rated “C”) and Time Warner (TWX, Rated “B”) mega-deal ... and the failure of the telecom tie up between Sprint (S, Rated “D+”) and T-Mobile U.S. (TMUS, Rated “B”) ... are also rattling investors.

Third, the proposed tax package from the Trump administration limits the deductibility of interest on corporate borrowings. That could boost the after-tax cost of raising money in the corporate bond market, putting financial pressure on lower-quality borrowers.

As a result, we’re seeing money come out of junk bonds for the first time in a long time. Lipper reported that investors yanked $622 million from junk bond funds in the most recent week after pulling $1.2 billion from them the week before.

But rather than panic, I’d encourage you to go shopping in the sector. The economy is still firmly on a growth path. The proposed tax package has several other measures that should boost GDP overall. That will help even troubled companies deliver stronger earnings and cash flow.

Plus, the biggest shock to the junk bond market – the meltdown in energy prices and surge in energy bankruptcies from 2015 and early 2016 – is behind us. Oil and gas prices have been firming up for several months now, with crude recently trading to its highest level since July 2015.

That all tells me this is nothing more than a credit market “hiccup,” similar to others we’ve seen that ultimately meant nothing. It does not look like a major negative turn in the credit cycle. So, look into buying higher-yielding ETFs if you need to boost the income your portfolio throws off – while you can still get them on sale!

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