2 High Yield ETFs Signal Credit Upheaval

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Years of low interest rates and minimal inflation have resulted in many ETF investors adopting these investments as surrogates for more conservative options. Furthermore, a prolonged period of relatively low volatility may have lulled these same participants into a false sense of security. 

The lesson that many are learning is that a reach for yield also comes with an associated greater risk of volatility in price.That volatility may be finally starting to rear its ugly head, as two heavily owned high yield funds have fallen precipitously in recent months.

Junk Bonds

The SPDR Barclays High Yield Bond ETF (JNK) tracks an index of nearly 800 corporate bonds in the U.S. with below investment grade credit ratings.These fixed-income securities are commonly referred to as “junk bonds” because of the issuers’ relatively precarious financial situation. Investors are then compensated for the additional risk by receiving a much higher coupon payment (or yield) than a Treasury or investment grade corporate bond. 

The current 30-day SEC yield on JNK is 7.23% and has been rising steadily as its price has dropped. By contrast, a 10-Year Treasury Note currently yields 2.23%.That puts the spread between a risk-free Treasury bond and the high yield bond index at nearly 5% (or 500 basis points). 

Since peaking in May, JNK has fallen more than 9% and continues to illustrate tightening risk behavior in the credit markets. 

JNK has $11 billion in total assets and charges an expense ratio of 0.40%. According to data from ETF.com, this fund has actually attracted $2.4 billion in additional net assets this year. This is likely the result of value-conscious income investors taking advantage of depressed prices to increase their portfolio yield.  

Nevertheless, as the chart above indicates, this index has yet to see signs that a reliable low has been put in place and the downtrend has been accelerating rapidly in recent months. Much of this misery has been blamed on falling energy prices, which make up a significant portion of the U.S. high yield debt market. A recent Charles Schwab research note opined that weakening commodity prices were to blame for higher volatility and an overall increase in distressed debt.

The weakness in JNK certainly warrants attention at this time because of its potential to leak over into other areas of the market. The trend in high yield credit may lead to additional nervousness in stocks or potentially signal a turning point to bolster a bullish case.

Master Limited Partnerships

Another corner of the high yield market that has come under fire this year has been publicly traded master limited partnerships (MLPs). These entities are engaged in the energy infrastructure business to provide storage, transportation, and processing of commodities.MLPs receive a special dispensation to pass the majority of their operating profits to shareholders in the form of dividends.This allows them to pay out very high yields relative to common stocks or bonds.

The largest exchange-traded fund in this space is the Alerian MLP ETF (AMLP), which has $6.4 billion in total assets.AMLP tracks an index of the 25 largest and most liquid entities in this sector. 

Unfortunately, the continued plunge in energy prices alongside the tightening credit environment has led to this fund dropping by 36% in 2015.That drop has rapidly increased the current yield on AMLP as well. Based on the most recent dividend, this index is now yielding 11.40%. 

The pernicious drop in this energy sector index illustrates the risk of chasing yield in unconventional asset classes. Many income investors became enamored with MLPs over the course of the recent bull market, only to realize how susceptible they are to both commodity prices and spillover from the high yield bond environment.

Nevertheless, the drop in 2015 hasn’t scared away fresh capital. AMLP has attracted $840 million of net new money so far this year as investors seek to capitalize on a turnaround in the energy sector or supplement their income producing assets.

The Bottom Line

The reach for yield is a double edged sword that can produce attractive income and capital appreciation at the cost of greater overall risk. Investors using these ETFs should be cognizant of those tradeoffs and carefully research the underlying holdings and price trends to determine if they are suitable for their objectives.