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Bond Market’s Mood Shifts Into Safety Mode

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Although most of the investing public’s attention is still focused on volatility in the U.S. stock market and fears of a further correction, the bond market has been filled with its fair share of drama.

High-yield bond ETFs like the iShares iBoxx $ High Yield Corporate Bond ETF (HYG) and SPDR Barclays High Yield Bond ETF(JNK) have fallen at least twice as much as the S&P 500 over the past three months — down 3.6% and 4.7%, respectively, compared to 1.8% for the S&P 500. They are the two largest high-yield bond ETFs; HYG has nearly $13 billion in assets while JNK has $9 billion.

Even more alarming is the rising level of individual high-yield bonds trading at distressed prices. Almost 15.7% of the 1,720 bonds rated below investment grade were in distress as of mid-September, according to Standard & Poor’s Ratings Services. This figure represents the largest number of speculative high-yield bonds at crisis levels in four years.   

Bonds from debt-saddled companies inside commodity-linked sectors like basic materials and mining are contributing to the jump in distress ratios, which will likely lead to debt defaults.

Any corporate bonds with a credit rating below BBB− are typically categorized as high-yield or junk bonds because borrowers have an unestablished or shaky credit history.

Although the risk of investing in high-yield bonds has always existed, many investors have ignored these warnings over the past several years.

Due to depressed interest rates driven by the Federal Reserve’s zero interest rate policy that dates back to 2008, yield-thirsty investors shifted money into hig- yield bonds hoping to collect more income. But while high-yield bonds pay higher income compared to investment-grade debt, these types of speculative bonds are loaded with credit risk.

Over the past few years, the real-world risks of owning high-yield bonds have been largely camouflaged by a sharply rising stock market. When stocks are appreciating, high-yield bonds tend to outperform safer investment-grade debt. Conversely, when stocks decline, high-yield bonds underperform.

The exodus away from higher risk bonds into safer debt actually began last year and proved to be a prescient warning sign that trouble in the stock market was ahead. The performance of the SPDR Barclays High Yield Bond ETF (JNK) has lagged the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) over the past year by around 4.5%. JNK’s relative underperformance compared to the safer investment grade LQD along with its lagging returns versus the S&P 500 suggests that bond investors are scaling back risk. And while high yield bonds have historically done best when stock prices rise, that hasn’t been the case since October 2014. 

Tactical advisors and traders that are short junk bonds have been making money.

The ProShares Short High Yield Bond ETF (SJB) has delivered a modest gain of almost 2% over the past three months. The ETF is built to deliver the exact opposite of the daily performance of high yield bonds. That means if junk bonds collectively lose 1% on any given day, SJB should be up 1%.    

If the sentiment shift in the bond market continues to move into “risk off” mode, it should mean more outflows from junk bond ETFs into safer assets like Treasuries and cash. It could also mean bigger gains ahead for junk bond bears.

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