Are High Yield ETFs Becoming Too Hot To Handle?

Love was in the air this Valentines week and many income investors are smitten with the returns of their high yield investments. The steady march higher in assets like junk bonds, preferred stocks, emerging market debt and even leveraged closed-end funds has remunerated shareholders for their faith.

The poster child of this strength may well be the iShares iBoxx $ High Yield Corporate Bond ETF (HYG).This well-known fund, which invests in a passive index of high yield U.S. corporate debt, has gained more than 22% over the last year. That jump includes both price gains and income distribution over a 52-week period. It also bests every corner of the U.S. fixed-income sector map by a wide margin. 

This low volatility environment has been good to shareholders of credit-sensitive bonds that have participated in the rally. However, I am always careful to remind investors that the strength of this trend comes at a meaningful cost as well. The inverse relationship between bond prices and yields precipitates the compression of future dividends. In the case of HYG, it is only sporting a 30-day SEC yield of 5.22% now and that statistic could soon start with a 4 handle.

Owners of high yield debt are now getting paid far less for the uncertainty of holding risky credit than they have since 2014. One look at a 5-year chart of the BofA Merrill Lynch US High Yield Option-Adjusted Spread Index should be a sobering experience.

This chart effectively measures the difference between a high yield bond index and a similar spot on the Treasury curve. It’s now trading at a spread of 386 basis points, which is down near levels not seen since 2014. That prior low in high yield bond spreads ultimately led to a period of volatility and above-average risk for shareholders.

This same compression in yields is happening across other areas of the credit spectrum as well.The iShares U.S. Preferred Stock ETF (PFF) yields just 5.5% at today’s prices.The iShares J.P. Morgan USD Emerging Markets Bond ETF (EMB) yields 4.92%. Even a lower duration junk bond fund such as the PIMCO 0-5 Year High Yield Corporate Bond ETF (HYS) is yielding just 4.13%. We have seen these funds trade with an additional 200 basis points or more in yield during the trough of a correction.

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