S&P Constructive on Junk Bond ETFs

Despite ongoing bubble calls and speculation the asset class is overvalued, junk bonds and the ETFs where those bonds make a home continue to defy the critics. Even after modest losses Monday, the largest high-yield bond ETFs are still found trading just pennies below their respective 52-week highs.

S&P Capital IQ says "high-yield ETFs will likely benefit from an improving economy and low-rate environment."

In a research note published Monday, S&P Capital IQ notes nearly $10 billion flowed into high-yield bond ETFs last year and that "high-yield defaults are at only 2.7% vs. a 4.5% long-term average."

While there has been ample talk that high-yield bonds are heading toward a bubble, some investors have noted the current environment for the asset class is not reminiscent of past bubbles. The argument being that much of the new issuance seen in 2012 was used for refinancing purposes, not to fund dividends or leveraged buyouts.

Increased confidence in an economic turnaround and the Federal Reserve's efforts to keep interest rates low for the foreseeable future are catalysts that could continue to bolster junk bond ETFs this year, according to S&P.

"In this low interest-rate environment and with confidence in the macro economy spurring investors to take on more risk, we think investors will continue to find high-yield ETFs attractive, in part because of their low cost structure," S&P analyst Todd Rosenbluth said in the note.

S&P Capital IQ highlighted the iShares iBoxx $ High Yield Corporate Bond Fund (NYSE:HYG) as one ETF investors can use to gain exposure to high-yield corporates. HYG is the largest junk bond ETF by assets with over $16.1 billion as of January 11. The fund has a 30-day SEC yield of 5.11 percent and an effective duration of 3.92 years.

Consumer staples, energy and financial services are HYG's largest sector weights. S&P said HYG hauled in $4.5 billion in new investments last year, making the number eight ETF of any type by 2012 inflows. HYG has gained about six percent in the past year.

HYG's most direct competitor is the $12.8 billion SPDR Barclays High Yield Bond ETF (NYSE:JNK). JNK features a 30-day SEC yield of 5.19 percent and a modified adjusted duration of 4.16 years. Modified adjusted duration is an option-adjusted measure of a portfolio's sensitivity to changes in interest rates. Calculated as the percentage change of a portfolio's value for a 100 basis point change in yield, according to State Street.

As has been previously noted, JNK has a tracking error issue, meaning the ETF has a tendency to lag its benchmark index by wide margins. S&P said JNK its index by 100 basis points through November 2012. JNK's tracking error issues have made it the preferred vehicle for professionals looking to short a broad basket of high-yield bonds.

S&P also highlighted the duration in its note, saying "Duration is another important consideration when investing in bond ETFs. Duration is a measure of the price responsiveness of interest-sensitive assets to changes in the interest rate, stated in years. So, if a fund has a duration of two years, that suggests for every 1% increase in the interest rate the price of the fund may drop by 2%."

The SPDR Barclays Short Term High Yield Bond ETF (NYSE:SJNK) one of the most successful new ETFs to come to market last year, is the lower duration answer to JNK. SJNK features a 30-day SEC yield of 4.56 percent and a modified adjusted duration of about 2.1 years.

SJNK has risen about three percent in the past year, but the ETF's ability to attract assets stands in stark to contrast to speculation that cash has been fleeing high-yield bond funds. On December 4, SJNK had less than $519 million in AUM, but started trading on Monday with almost $701 million in assets, according to State Street data.

"The assets this ETF attracted in such a short time are pretty impressive. Along with its low-cost structure and relatively large payout, it provides exposure to high yield with a duration offset for the investor who believes interest rates may climb faster than either the Fed or Standard & Poor's Economics believes," Rosenbluth says.

For more on junk bond ETFs, click here.