Is Caution Warranted On Junk Bond ETFs?

With bond markets increasingly pricing in higher odds that the Federal Reserve will boost interest rates, it is not surprising that investors are departing corporate bond exchange-traded funds this quarter. In the current quarter, three of the six worst ETFs in terms of assets lost are corporate bond funds, including the two largest junk bond ETFs.

Mass departures from junk bond ETFs, including the SPDR Barclays Capital High Yield Bnd ETF JNK, can prompt concerns about the ability of these ETFs to handle large-scale exits, underscoring the importance of the secondary market for junk bond ETFs.

The secondary market for junk bonds and ETFs like JNK is vital because during times of heightened market stress, over-the-counter high-yield bond market liquidity can and does evaporate, forcing the bulk of trading into the largest, most liquid issues.

As was seen during the taper tantrum of 2013, the secondary market for ETFs bolsters available fixed income market liquidity and can act as an efficient price discovery mechanism for the issues held by a fund such as JNK.

Indeed, activity in ETFs such as JNK has recently been brisk.

“Investors are running hot and cold on the asset class, rushing into or exiting high yield based on macro events. For instance, in September investors sold $2.8 billion of the ETFs after being disappointed by the European Central Bank’s decision to not provide additional stimulus, but the selloff quickly reversed after $3.2 billion was reinvested in response to the Federal Reserve’s (Fed) decision to not raise rates,” said State Street Vice President David Mazza in a recent note.

JNK's modified adjusted duration is just 4.3 years, hardly the makings of longer-dated fare, indicating that just one interest rate hike is unlikely to derail demand for junk funds over the long haul. Assuming the Fed makes good on its promise to raise rates gradually, yield-starved investors could continue allocating to the likes of JNK.

“Recent developments may support this improved sentiment and demand for yield — at any — price [emphasis omitted]. While the Fed is expected to raise interest rates in December, the prospect for significantly higher US rates in the near term has fallen. There is also limited evidence that we will see a reversal of accommodative policies by global central banks. The continued low rate climate should fuel demand for higher yielding debt as income generation is a persistent need,” added Mazza.

JNK has a 30-day SEC yield of 5.8 percent, more than triple the yield on 10-year U.S. government bonds.