Junk Bond Fund Outflow: Cause For Concern?

After a fairly strong start to 2019, the high-yield bond market has struggled so far in March. CCC-rated “junk” bonds declined for three consecutive days in early March for the first time this year, and Lipper recently reported U.S. retail investors withdrew $1.9 billion from high-yield bond funds in the week ending March 6.

The Numbers

The exodus from high-yield bond funds came after five consecutive weeks of inflows. Investors were most aggressively selling ETFs such as the iShares iBoxx $ High Yid Corp Bond HYG. Junk bond ETFs endured an outflow of $1.3 billion on the week. High-yield mutual funds logged outflows of $582 million.

While the near-term trend might be a bit concerning for bond investors, there has been much more buying than selling this year. Year-to-date inflows for junk bond funds are around $7.8 billion.

The U.S. nonfinancial corporate bond market is now $5.7 trillion in size, double the size it was just 10 years ago, according to Dallas Federal Reserve Chief Robert Kaplan.

Investment-grade bonds rated BBB or higher make up nearly 80 percent of the market. Yet about 60 percent of investment-grade bonds are BBB-rated, the lowest tier above junk status. One potential concern is that this massive group of BBB-rated bonds would likely lose their investment-grade status during an economic downturn — and the junk bond market could become flooded with loans.

Economic Risks

Kaplan recently said that extreme growth in the U.S. corporate debt market, particularly in the junk bond market, has created risks for the economy.

“A number of research studies have indicated that relatively higher levels of corporate debt-to-GDP could potentially amplify the severity of a recession,” Kaplan said.

A bond market downturn would result in a spike in yields, which could adversely impact corporate investment and spending, he said. 

“In the event of an economic downturn, these issues could also contribute to a deterioration in financial conditions which could, in turn, amplify the severity of a growth slowdown in the U.S. economy." 

Of course, with the Federal Reserve recently suggesting it will put interest rates on pause in 2019, and with rates in the eurozone and other global economies at or near zero, the lure of high yield corporate bonds is still appealing to global investors.

The struggling General Electric Company GE recently said more aggressive investing in junk bonds is a major part of its strategy to shore up its insurance business.

Comparisons To 2008

The good news for junk bond investors is that the collateralized loan obligations that make up a large portion of the junk bond market appear to be much more robust than the mortgage-backed security market that collapsed during the financial crisis of 2008, Kaplan said.

"Unlike mortgage-backed securities, the CLO structure proved relatively resilient during 2008-09," he said. "However, it is important to recognize that CLO loan-credit quality today is estimated to be somewhat weaker than 10 years ago."

Fortunately for junk bond investors, the recent sell-off may have finally stabilized for now. The HYG is down just 0.1 percent overall in the past five trading sessions.

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