ETFtrends: Are High-Yield Bond ETFs Overvalued After Big Run?

etftrends logo imagesCourtesy of John Spence

Junk bond ETFs have enjoyed four solid years of returns while investors’ hunger for income-producing assets has pushed the sector’s yields down near record-low levels. As 2013 gets underway, some investors are again wondering if high-yield corporate debt is overvalued after such a strong run.

The only problem is that investors don’t have too many other options when it comes to finding yield with the Federal Reserve committed to keeping rates low for a couple more years.

“With record fund inflows in 2012, investors clearly have an appetite for high-yield bond funds,” says Morningstar analyst Timothy Strauts. “The strong investor demand lowered credit spreads, and the high-yield category returned over 14% last year. While yields have been falling, high yield is the only bond category with a 12-month yield still above 5%.”

SPDR Barclays High Yield Bond (NYSEArca: JNK) and iShares iBoxx High Yield Corporate Bond (NYSEArca: HYG) are the largest ETFs that invest in high-yield corporate debt. The funds were big sellers in 2012 and allow investors to buy a basket of high-yield bonds with one trade and low fees.

The sector’s rally has pushed the average yield on speculative grade bonds below 6% for the first time ever. [Junk ETFs Highest Since 2008]

Fed-fueled bubble?

“One of the aims of the Federal Reserve interest rate policy is to increase risk-taking across the capital markets. High yield is one of the main beneficiaries of the Fed’s current policy. With yields of investment-grade securities below 3%, investors have been forced to look elsewhere for income. Many institutional investors that in the past only chose investment-grade bonds have been buying high yield to meet their return targets,” says Strauts at Morningstar.

“This new demand has pushed yields down and given corporations the ability to refinance a lot of debt in 2012. It was a record year with over $300 billion in new bond issuance. The ability for even very low-rated, highly leveraged companies to get financing has helped many firms stay afloat when they would otherwise have defaulted in a normal year,” he wrote in a recent commentary. “The high demand for these speculative issues has caused some investors to discard fundamentals in favor of searching for the highest yield without regard for quality. This strategy has worked so far, but at some point demand will soften, poor business fundamentals will catch up with firms, or the Fed will change its policy.”

Despite worries that high-yield bonds are in a bubble, corporate defaults are below the historical average.

Although high-yield bonds are often considered high-risk and speculative, the asset class has outperformed the S&P 500 the past five years with less volatility, says Peritus Asset Management, the subadvisor for Peritus High Yield ETF (NYSEArca: HYLD). [ETF Focus: Peritus High Yield]

For the five-year period ended Dec. 31, 2012, the S&P 500 had an annualized total return of 1.65%, compared with 9.53% for the Credit Suisse High Yield Index. The S&P 500 had an annualized standard deviation of 19.04% versus 12.89% for the high-yield index during the period, according to Peritus.

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