Can Junk Bond ETFs Survive Sharply Higher Interest Rates?

From Zacks: Year 2017 started on a troubled note for junk bond ETF investors. These ETFs have been garnering a lot of attention since last year on investors’ desire for higher yields in the ultra-low rate interest environment.

However, the high-yield junk bond market has entered a precarious zone with a lift in outlook for the U.S. and possibility of an accelerated rate hike trajectory. They encountered a broad-based sell-off especially after Donald Trump won the election (read: 5 ETF Investment Ideas for 2017).

The U.S. President-elect plans to increase economic stimulus, which is likely to push long-term interest rates higher. Additionally, the Federal Reserve’s hiking of interest rates in December and hints of an aggressive fiscal policy ahead did not help the case of junk bond ETFs either.

The Fed raised the benchmark interest rates by 25 bps to 0.50–0.75%, citing the U.S. economy’s growth momentum and a strengthening labor market. The Fed expects three rate hikes each in 2017, 2018 and 2019. Several members of the Fed’s Federal Open Market Committee are of the opinion that the rate hikes could come more frequently than anticipated.
Treasury yields are also showing upward movement. Bank of America Merrill Lynch estimates that the 10-year Treasuries will yield 2.65% by the end of 2017. The possibility of an accelerated rate hike also brings with it a shift in investors’ sentiment, which does not bode well for junk bonds (read: Sole Fed Hike of 2016 Put These ETFs in Focus).

Contrarian View

The U.S. economy is gradually improving and witnessing impressive labor market, rising wages, slowly rising inflation and increasing consumer spending. A combination of factors like return to the earnings growth era, a jump in oil price, Trump’s pro-growth policies and the rise in interest rates added to the strength.

Strengthening economy will help diminish credit risk of the junk bonds. Due to junk bond’s reportedly “equity-like” nature these could benefit from higher growth environment in the U.S. Trump’s protectionist policies and tax cuts could support high-yield companies with relatively larger exposure to the U.S. market (read: 5 U.S. Equity ETFs Beginning 2017 with a Bang)

Additionally, although interest rates are rising, these are still low. Meanwhile, Fed chair Janet Yellen has taken a cautious stance. She indicated that further hikes largely depend on what policies are brought in by Trump and how they impact the economy.

Below, we highlight a few popular junk bond ETFs that are likely to be in the spotlight in 2017. All ETFs mentioned below carry Zacks ETF Rank of 4 or a ‘Sell’ rating with a High risk outlook (see all High-Yield/Junk Bond ETFs here).

iShares iBoxx $ High Yield Corporate Bond ETF (HYGFree Report)

It is the largest and most liquid fund in the high yield bond space with an AUM of $18.9 billion and average daily volume of more than 12.1 million shares. The fund charges investors 49 bps in fees per year. The fund tracks the Markit iBoxx USD Liquid High Yield Index and holds 1,032 securities in the basket. Effective duration and average maturity are 3.85 and 4.33 years, respectively.

SPDR Bloomberg Barclays High Yield Bond ETF (JNKFree Report)

This product accumulated about $12 billion in its asset base. It offers exposure to the high yield corner of the bond ETF world and follows the Bloomberg Barclays High Yield Very Liquid Index. The fund holds 768 corporate bonds with modified adjusted duration of 4.02 years. Expense ratio came in at 0.40% while volume is robust as the fund exchanges more than 11 million shares a day (read: Can Bond ETFs Continue Their Dream Run in 2017?).

PowerShares Fundamental High Yield Corporate Bond Portfolio ETF (PHBFree Report)

This ETF is based on the RAFI Bonds US High Yield 1-10 Index. The fund manages an asset size of over $1.1 billion and an average daily trading volume of 794,000 shares. The fund charges an expense ratio of 50 basis points a year and has an effective duration of 3.64 years.

VanEck Vectors Fallen Angel High Yield Bond ETF (ANGLFree Report)

This fund tracks the BofA Merrill Lynch US Fallen Angel High Yield Index. The ETF manages assets worth $504 million and an average daily trading volume of 250,000 shares. The fund charges an expense ratio of 35 basis points a year and has an effective duration of 6.27 years.

The iShares iBoxx $ High Yield Corporate Bond ETF (NYSE:HYG) was unchanged in premarket trading Thursday. Year-to-date, HYG has gained 0.83%, versus a 1.60% rise in the benchmark S&P 500 index during the same period.

HYG currently has an ETF Daily News SMART Grade of A (Strong Buy), and is ranked #1 of 35 ETFs in the High Yield Bond ETFs category.

This article is brought to you courtesy of Zacks Research.

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