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Junk Bond ETFs: Another Big Short

by John Rubino on August 22, 2010 · 20 comments

Sometimes the market makes it too easy. Check this out:

Desire for income drives high-yield bond ETFs’ popularity

BOSTON (MarketWatch) — Investors fed up with U.S. stocks’ negative returns over the past decade and paltry rates in today’s fixed-income markets are piling into exchange-traded funds that invest in high-yield corporate bonds.

“Where else can you get an 8% yield? The S&P 500 (MARKET:SPX) is flat over the last dozen years,” said Matt Hougan, head of ETF analytics at IndexUniverse. “I’m not surprised people are looking elsewhere on the capital spectrum.”

Still, investors need to be wary of the higher risk in “junk” bonds, which can manifest itself in big price swings relative to other categories of bonds. Structurally, Hougan noted the high-yield bond ETFs can trade at “significant premiums” to their net asset values. ETFs following less-liquid markets can see wider trading spreads.

Two high-yield ETFs with large asset bases — iShares iBoxx $ High Yield Corporate Bond Fund (CONSOLIDATED:HYG) and SPDR Barclays Capital High Yield Bond ETF (CONSOLIDATED:JNK) — both saw year-to-date inflows of more than $1.2 billion through July, according to data from the National Stock Exchange. More cash likely moved in the door this month amid a surge in bond issuance from corporate America.

The high-yield bond ETFs rallied in 2009 on easing economic and credit concerns, but are essentially treading water so far this year. The SPDR Barclays Capital High Yield Bond ETF gained 37.7% in 2009, according to investment researcher Morningstar Inc., as worries over defaults and bankruptcies eased. The fund lost 24.7% in 2008 as the credit storm raged. Both ETFs are currently yielding around 8%.

Hunting for income

With six-month certificate of deposit rates averaging less than 1% nationally according to BankRate.com, it’s no wonder many individuals are looking well beyond traditional savings accounts for income. The Federal Reserve has indicated it intends to keep short-term rates near zero to help stimulate the troubled economy and job market.

“The measly yields offered by the vast majority of fixed-income securities have forced investors to step up their hunt for current returns,” said Michael Johnston, senior analyst at ETF Database. “For many, that search has led to junk bonds.”

Although low rates have punished savers and investors approaching or in retirement who rely on income, they need to consider the risks of bond funds that are offering tempting yields, such those that invest in paper from companies that have lower credit ratings.

Investing in high-yield corporate bonds is “similar to investing in the equities of companies with highly leveraged balance sheets,” said Morningstar ETF analyst Timothy Strauts.

In his latest report on SPDR Barclays Capital High Yield Bond, he said the ETF “should be viewed as a satellite holding, and a risky one at that.” The fund takes an indexed approach with 166 holdings. The expense ratio is 0.4%, compared with 0.5% for iBoxx $ High Yield Corporate Bond Fund.

Some investors may be drawn to junk-bond ETFs because their yields are much higher than those offered by Treasury funds.

“With increased leverage comes the increased probability of default and bankruptcy,” says Morningstar’s Strauts. “In the grand scheme of things, risk equals return, and the ‘high’ yield of these bonds is designed to compensate investors for this risk.”

Recently, there are signs volatility in equity markets “has taken its toll on retail investor enthusiasm about high-yield bonds,” said Oleg Melentyev, credit strategist at Banc of America Securities LLC, in an Aug. 9 research note.

The strategist said inflows into the fund sector slowed to $50 million in the latest week, a “marked departure” from intakes of at least $500 million seen in each of the previous five weeks.

The volume of U.S. junk bonds has topped $155 billion this year and is on pace to break 2009’s record, The Wall Street Journal reported earlier this month.

Some thoughts:

  • I used to be a junk bond analyst and learned from that experience that the math generally doesn’t work. Think about it. If you buy a junk bond at par and its price rises because the issuing company is doing well, they’ll call the bonds away from you. So your upside is limited to the coupon plus a modest take-out premium. But your downside risk if the company runs into trouble — as a big percentage of junk issuers do — is much higher, frequently 50% or more.  Even in good times these aren’t attractive odds.
  • The default rate for junk bond issuers has been very low lately. This is always the case when money is easy, because even weak companies are able to avoid default by refinancing their loans. But when the economy turns down or interest rates rise you discover, as Warren Buffett likes to say, who’s been swimming naked. Typically the junk market has a lot of skinny-dippers.
  • The whole sad story of junk bond ETFs is encapsulated in a quote early in the article: “Where else can you get an 8% yield?” It illustrates a point that tends to be missed by small investors who are induced by Wall Street to pile into risky instruments, which is that yield and return are two different things. A bond can yield 10% but return -10% if its price drops by 20%. So buying the highest yielding security is a fairly sure way to get a positive yield and a negative total return. The current generation of yield chasers will learn this lesson in 2011.
  • Their tragedy is an opportunity for the rest of us, because junk-bond ETFs can be shorted like stocks. And as if they weren’t leveraged enough, these things have options! So short the ETFs, write covered puts on them to lower your cost basis, and wait for the market to show signs of cracking. Then close the covered puts and let your shorts ride. This is as close to a no-brainer as we’re going to get.

 

  • D

    If you borrow the share to short, wouldn’t the borrower have to pay the dividend?

    • John Rubino

      D,

      Yes, which makes shorting a junk bond ETF an expensive speculation if it takes too long to work out. But writing puts against your short positions will generate more than enough cash to cover the dividends. The trick will be to take off the covered puts at the right time so you’re unhedged when the junk market starts to tank.

  • Rich

    I was thinking the same thing. The two asset classes (stocks and junk) have diverged considerably over the last couple months.
    http://finance.yahoo.com/echarts?s=SPY+Interactive#chart6:symbol=spy;range=3m;compare=jnk;indicator=volume;charttype=line;crosshair=on;ohlcvalues=0;logscale=on;source=undefined
    This looks like a fairly low risk (very slim chance that junk bonds rally considerably from where they are), high reward (decent chance that stocks/junk fall from current levels) proposition.

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  • http://www.billhopen.com billhopen

    Its like shorting US Treasuries, because the “company” is 200 trillion in the hole. It may take an awfully long time for the eventual crash….everyone has to believe, wants to believe, looks only at yield, because loosing principal to default is unthinkable…..hmmm, kinda like MBS’s in 2006

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  • Mike

    I always enjoy reading your recommendations.

    What do you recommend that will profit the most during a full-blown Wall Street Crash?

    I’m already hooked on VXX and FAZ. Is there anything else that is comparable or better?

    Also, is there a similar product that will do well when municipal bonds finally implode as they inevitably will?.

    • John Rubino

      Mike, sorry to take so long to respond. It’s a vacation week. I’ll do a piece on shorting munis in a few days.

      John

  • http://icliks.wordpress.com icliks

    Buy AFBIX and let them do all the work for you.

  • Brad Thrasher

    Gentlemen:

    Given all the evidence of corruption and market manipulation why anyone would participate in the markets at this time is the one thing I find most puzzling.

    Still, over the past couple months I’ve tried to do a couple things but each time, lack of trust, respect or fear of the unknown, risk/reward has prevented me from pulling the trigger.

    Anybody out there ever get “trading block?”

    All the best,
    Thrash

  • emma

    I dont think its ready to go bye bye just yet.

    The guy who was laughed at while all this was happening was right all along. He actually called the market crash and the big run up on gold. What he says now is very interesting.

    Here is his latest cheeky show http://www.youtube.com/watch?v=yMCuSLqd0Gg

  • Mike

    ty John. I look forward to it. :-)

  • JJ

    Hi

    I am not as smart as you guys, and there must be a flaw in my thinking, but if you were to invest in the HYG 3 years ago, it was paying about 8%. Even though it dropped about 40% in the crash, and has only recovered to -15%, you still would have earned 24% in dividends over three years, which would more than cover the 15% loss. (Getting paid to wait.) Not the greatest return, but better than some have done in stocks, so I would say the HYG did pretty well given the extraordinary circumstances.

    I have to believe that there were some companies that failed in the crash, but given that the HYG is made up of ~350 different companies, no one company is more than about 1% and most are much less than that. IMO, something much bigger than the recent crash would have to happen to destroy the HYG.

    Given that this site seems to be about the coming “financial armageddon”, I don’t see that stocks would fare any better as an asset class under those conditions, so why pick on the HYG (and the like) as being “particularly” risky.

    Best Regards

    JJ

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  • UbaTuba

    Could you give an example: Based on todays price of shorting HYG, then buying Puts against it? When would you consider HYG to be “cracking” and close of the Puts prudent?

    Thanks!

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  • http://www.manhattancalumet.com james moylan

    I have a web site where I research stocks under five dollars. I have many years of experience with these type of stocks. I would like to comment about high yield bonds the time to buy high bonds would have been back in 2008 and 2009 when they were yielding over twenty percent.


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