Why You Need to Sell Your High-Yield Bond ETF NOW

If you own iShares iBoxx $ High Yield Corporate Bond ETF (HYG), SPDR Barclays High Yield Bond ETF (JNK) or any of the various mutual funds linked to high-yield indices, you’re sitting pretty. High-yield bonds have provided strong long-term returns, above-average income, and substantial outperformance versus the rest of the bond market during the past 12 months.

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But don’t be fooled: High yield now offers an extremely unattractive tradeoff of risk and return. It’s time to cash in your gains and seek opportunities elsewhere.

Here’s the core problem with high yield: The return advantage is no longer sufficient to compensate investors for the potential downside. As of May 21, the yield of the BofA Merrill Lynch US High Yield Master II Index stood at just 5.43% according to the Federal Reserve Bank of St. Louis (FRED) database. This compares to the average yield of 9.6% from 1996 onward, and it’s the near the all-time low of 5.24% registered in May 2013.

Of course, the value of high yield bonds is gauged by their yield spread versus Treasuries more so than their absolute yields. But high yield is also expensive on this count: at 3.77, the spread is well below the long-term average of 5.88 and near its lowest level since July, 2007.

What does this mean for investors in bond ETFs? Very simply, it indicates that yields are very low compared to the lower-risk alternatives. HYG and JNK currently yield 4.35% and 4.73%, respectively. In comparison, the Vanguard Total Bond Market ETF (BND) yields 2.12%. This indicates that the average retail investor is only picking up an extra 2.2 to 2.6 percentage points’ worth of extra yield by investing in high-yield bonds.

Bulls have made the case that this paltry yield advantage is supported by the combination of low defaults, modest economic growth, healthy corporate balance sheets, and accommodative Federal Reserve policy. Further, below-investment-grade companies have taken advantage of the low-rate environment to refinance their debt, which removes the risk of a “maturity wall” occurring in the near term (in other words, a wave of maturing debt that could trigger defaults).

This favorable credit picture has been fuel for the rally in high yield, and it doesn’t look set to change any time soon. The trouble is, these developments are already reflected in the market via low spreads and strong recent returns. What isn’t reflected is two additional risks that investors seem to be approaching with a complacent attitude.

First is the potential for higher Treasury yields. While high yield bonds aren’t usually rate-sensitive, the situation is different right now because low yield spreads amplify the impact of rate movements. This is particularly true for the higher-rate segments of the high yield market (bonds rated BB), where absolute yields — at just 4.29% — are sitting just above the record low set in 2013.

The second issue is the ever-present potential for a shift in investor risk appetites. Since so much of the rally in high yield has been driven by yield-seeking investors looking for alternatives to government debt, a reversal of inflows could lead to a corresponding reversal in performance. This makes high yield vulnerable to global developments and/or stock market weakness, setting up the potential for price weakness even if defaults remain low.

If this occurs, ETFs such as HYG and JNK will be in the bulls-eye of the selling pressure. This pressure could come from selling in the more liquid securities in the major indices (i.e., those most heavily represented in the ETFs) as well as the withdrawal of cash from the ETFs themselves, which could send their market prices to a discount versus net asset value.

Is it worth taking on these risks for an extra two-plus percentage points of yield? Absolutely not. In fact, it’s the very definition of an unfavorable risk-reward profile. A look back through history shows that price declines in high yield have happened with a high frequency, which indicates that the modest yield advantage could be wiped out in a matter of days or weeks if conditions become unfavorable. This is easy to forget, given that high-yield bonds have gone two years with only one significant break in their rally.

The bottom line: The combination of low yields and investor complacency leaves no margin for error in high yield. Investors in HYG and JNK are now in the position of “picking up pennies in front of the a freight train.” If you own these funds, sell your position and book your gains. You will almost assuredly have an opportunity to re-establish your position at a lower price by this time next year.

As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.

Article printed from InvestorPlace Media, https://investorplace.com/2014/05/high-yield-bond-etfs-hyg-jnkw/.

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