Why Investors Got Skittish About Junk Bond ETFs

High-yield corporate bond exchange traded funds sold off last week, but some bond market observers believe the sudden retrenchment in junk bond market wasn't surprising.

The iShares iBoxx $ High Yield Corporate Bond ETF HYG and the SPDR Bloomberg Barclays High Yield Bond ETF JNK, the two largest junk bond ETFs by assets, are both down 2 percent over the past week. Investors are departing junk bond ETFs, but even with the recent outflows, HYG and JNK have nearly $30 billion in assets under management. Given that heft, when these ETFs cough, many traders ponder whether equity markets are getting a cold.

Compressed spreads are seen as a contributing factor to last week's junk bond ETF pullback. Junk bond spreads are a measure of credit risk.

Analyzing Spreads

“The sell-off should not have been much of a surprise given how tight high yield spreads had become. To start November, high yield bond spreads—a measure of credit risk—were 34 percent below their 20-year median,” said State Street. “These spreads have compressed by more than 150 basis points in the last year alone. A little mean reversion was therefore not unfathomable given the yearlong rally in high yield.” 

JNK holds just over 970 junk bonds, of which more than 15 percent carry speculative CCC ratings or lower. HYG holds over 1,000 issues of which a combined 11.7 percent are rated CCC or CC. Those tighter spreads could continue to be a problem for HYG and JNK.

“The high yield market did look a bit stretched, as spreads had tightened considerably and convexity turned noticeably negative,” said SSgA. “Looking ahead, the call provisions embedded in these bonds may still limit future high yield gains, as issuers may call higher coupon bonds and replace them with lower coupon notes based on the lower prevailing market rate, resulting in an asymmetrical return profile with more downside than upside.”

Problematic Politics

Another factor working against riskier fixed income assets is the Trump Administration's tax reform effort, which was initially cheered by markets, but is now a source of consternation because investors are doubting whether or not the tax bill will even be voted on before the end of 2017.

“As jitters arose that tax reform might go the way of health care reform at the same time the market faces a looming debt ceiling debate, risk assets sold off,” said SSgA. “High yield did not lead the way. High yield fell more than large-cap stocks, as represented by the S&P 500 Index. But small-cap stocks, which are more domestically oriented than large caps and tend to have higher taxes, fell more than high yield.”

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