Funds and etfs

Junk Bond ETFs Are Starting to Look a Little Riskier

Junk bond exchange-traded funds (ETFs) have had a great year driven by a combination of overpriced equities and the search for yield. In fact, the SPDR High Yield Bond ETF (NYSE ARCA: JNK) performed nearly as well as the SPDR S&P 500 ETF (NYSE ARCA: SPY) over the equity bull market beginning early this year. The problem is that high yield bonds could become an overpriced asset class of its own given the high level of interest in the space.

In this article, we will take a look at why junk bonds could be a risky bet for the second half of the year, as well as some ETFs that might be most exposed.

Risk Off is Coming

The crude oil market experienced a sell-off over the past month, with the black commodity plummeting more than 20% over the past 30-day period. In general, crude oil prices have been highly correlated with junk bond prices. Crude oil and junk bonds are both good indicators of investors’ willingness to assume risk, since they tend to rise when the economy is improving and fall when the economy is at risk of falling into downturns.

The divergence between crude oil and junk bonds could be an indicator that investors’ are looking to de-risk their portfolio, but perhaps are still holding on to higher yields offered by junk bonds. Of course, the problem is that junk bonds will eventually have to move lower if the economy’s underlying fundamentals deteriorate, since there will be a higher risk of default for many companies – particularly in the oil and gas sector.

Worsening Earnings

The idea that investors may be starting to worry has been reinforced by poor earnings reports, which suggest that the U.S. economy may be struggling. According to the WSJ, S&P 500 companies are expected to report an earnings decline of 4.7%, which follows a 5% drop in the first quarter and would be the fourth straight quarter of declines. Revenue among these companies is also expected to fall by 0.8% in its sixth straight quarterly drop.

There are many different catalysts for these falling earnings. First, declining crude oil prices have put pressure on many energy companies, such as Chevron (NYSE: CVX) that recently reported a horrendous quarter. Second, low interest rates have put a squeeze on financial companies that rely on interest rate spreads to generate an income. And finally, the slowing smartphone market has put strain on Apple (NASDAQ: AAPL) as a large component.

Exposed ETFs 

There are many different ETFs that could suffer if investors continue to sell risky assets and move into safe-haven assets.

The most popular junk bond ETFs include:

  • iShares High Yield Corporate Bond ETF (NYSE ARCA: HYG)
  • SPDR High Yield Bond ETF (NYSE ARCA: JNK)
  • PowerShares Senior Loan Portfolio ETF (NYSE ARCA: BKLN)

The worst affected ETFs may be those with great exposure to the energy markets, since declining crude oil prices are likely to continue hurting the space.

The Bottom Line

Investors may want to consider transitioning out of junk bond ETFs – or at least reducing their exposure – given the current risk-off sentiment.