Be Realistic With Junk Bond ETFs

Less than five months into 2016, it is not a stretch to say that, particularly in comparison to last year, things are pretty good for high-yield corporate bond exchange-traded funds.

The iShares iBoxx $ High Yid Corp Bond (ETF) (NYSE:HYG) and the SPDR Barclays Capital High Yield Bnd ETF (NYSE:JNK) are each up more than 5 percent year-to-date, and investors are flocking to junk bond funds. Only nine ETFs have added more new assets than the $2.28 billion added by JNK.

The Appeal Of 'Junk'

Data suggest investors are increasingly turning to junk bond ETFs to express views on the high-yield bond market rather than individual bonds. That can be seen as a sign that some professional investors view junk bond ETFs as more liquid than the bonds held by these funds. Additionally, data suggest junk bond ETF volume has been on the rise this year.

So, flows to some of these funds are on the rise. Volume is as well, but investors that are expecting a lot more upside from high-yield bond ETFs should temper those expectations.

[S]harply rising commodity prices since February have translated into steeply falling high yield commodity sector spreads. The energy and materials sectors have disproportionately contributed to U.S. high yield performance overall. These sectors account for nearly half of high yields total return since the mid-February lows, though they represent less than 20 percent of the market, our analysis shows, said BlackRock in a recent note.

It May Be A Trend, But Not All Trends Last

In other words, what worked against high-yield ETFs last year, namely energy and materials issues and CCC-rated debt, is working in favor of those funds this year. However, that still levers junk debt to the same old problems: A stronger dollar and Federal Reserve rate hikes. Fortunately, the aforementioned ETFs have gotten passes on both fronts this year, but that does not mean that trend will last indefinitely.

Additionally, some commodities prices are rallying with little support from supply and demand dynamics. For example, oil has soared with next to no help in the form of OPEC production cuts.

We need to see improved supply-demand fundamentals for a sustained broad commodity rally, and the evidence of that so far is mixed. This means that high yield returns going forward will depend less on the commodities sector and more on evidence of broadening economic growth. A low growth outlook and the recent narrowing of spreads imply that we are likely to see more muted returns going forward, added BlackRock.