Speculative-grade, junk bonds have staged an impressive recovery from the February lows, but face mounting risks, notably from commodity producers. Investors, though, can diminish credit risks associated to more troubled areas through targeted high-yield bond exchange traded funds.
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The junk bond market faces heightened default risks ahead. According to Moody's Investor Service, default rate for all rated corporate issuers is expected to rise to 2.1%, a post-financial crisis high, from 1.7% in 2015.
"Persistently low commodity prices, slowing economic expansion and widening high-yield spreads will send default rates higher in 2016," Sharon Ou, a Moody’s credit analyst, said in a recent research note.
Among the trouble spots, energy and materials sectors stood out. In 2015, metals and mining sector had the highest default rates at 6.5%, followed by oil and gas at 6.3%. As commodity prices continued to fall off, Fitch Ratings calculated that energy high-yield defaults jumped to a record 13%, surpassing the previous 9.7% high in 1999.
Consequently, given the heightened credit risk, fixed-income investors may consider junk bond funds that lean toward higher quality debt. For instance, the Market Vectors Fallen Angel High Yield Bond ETF (NYSE:ANGL) tracks so-called fallen angel speculative-grade rated debt, or debt securities that were initially issued with an investment-grade rating but were later downgraded to junk territory. Fallen angel issuers tend to be larger and more established than many other junk bond issuers. Furthermore, since these fallen angels were formerly on the cusp of investment-grade status, this group of junk bonds typically has a higher average credit quality than many other speculative-grade debt-related funds. ANGL’s credit qualities include low investment-grade BBB 6.6%, along with speculative-grade BB 73.9%, B 9.8%, CCC 3.5%, CC 0.1% and non-rated 2.9%.
The PowerShares Fundamental High Yield Corporate Bond ETF (NYSE:PHB), which tracks the RAFI Bonds US High Yield 1-10 Index, also focuses on slightly higher quality corporate debt securities than its major competitors. The underlying Research Affiliates index implements a fundamental or smart-beta indexing methodology that screens for four factors, including gross sales, gross dividends, cash flow and book value of assets for each issuer. The end result is an index of company debt with higher credit ratings, including some low-investment-grade BBB 19%, along with speculative-grade BB 55% and B 26%.
In contrast, the widely observed SPDR Barclays High Yield Bond ETF (NYSE:JNK) and iShares iBoxx $ High Yield Corporate Bond ETF (NYSE:HYG) include junkier speculative-grade holdings. Specifically, HYG holds 0.4% BBB-rated debt, 50.8% BB, 36.7% B, 11.5% CCC, 0.8% CC and 0.01% C. JNK includes BB 42.5%, B 41.4% and CCC or lower 16.0%.
The slightly higher credit quality may also help explain why ANGL and PHB are outperforming HYG and JNK. Year-to-date, PHB advanced 5.9% and ANGL increased 12.3%, whereas HYG rose 4.6% and JNK gained 4.5%. However, the tilt toward higher credit quality means that funds have a slightly lower yield. ANGL shows 6.54% 30-day SEC yield and PHB has a 4.84% 30-day SEC yield while HYG has a 6.61% 30-day SEC yield and JNK comes with a 6.85% 30-day SEC yield.
After the recent rebound in junk bonds, some high-yield ETF investors may be calling it a top. HYG experienced 27.8 million share redemptions, or about $2.6 billion in outflows, over the past four days while the SPDR Barclays High Yield Bond ETF (NYSE:JNK) saw outflows of $245.7 million over the past week. In contrast, ANGL and PHB, though, have bucked the trend, adding $24.3 million and $23.7 million, respectively, in net inflows over the past week, which suggests that while investors may be trimming speculative-grade positions, higher quality junk still remains a solid play.
The junk bond market may still have legs. Even with the recent rebound, there is still a high premium to hold speculative-grade debt over safer government bonds. According to Bank of America Merrill Lynch data, yields on junk-rated bonds were 639 basis points over comparable government bonds. Looking at the ETFs, ANGL, which has a 5.73 year duration, shows a 6.54% 30-day SEC yield while 5-year Treasury bonds show a 1.20% yield.
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