Advisors searching for yield in the current continuous low-yield bond market may want to think twice before adding high-yield debt to portfolios. To say that the sector has been volatile would be an understatement, especially in the most popular high-yield ETF, the iShares iBoxx High Yield Corporate Bond ETF (HYG).
After a 12% rally from mid-February through the end of April, investors have withdrawn billions from high-yield ETFs — the bulk from HYG — and prices fell. HYG saw $3.6 billion in outflows during the six trading days that ended Friday, May 6 — a record decline and more than twice the previous record.
Some analysts attribute the outflows to a change in sentiment about high-yield bonds; others to sales of ETF shares in order to purchase the underlying securities. But whatever the reason, the high yield market has been falling after a strong rally earlier this year, and the outlook has turned bleak.
Jim Bianco, president of Chicago-based Bianco Research, subscribes to the change-in-sentiment analysis, based on a lack of data showing ETF outflows moving into the underlying bonds. He says money is leaving the high-yield market in large part because corporate earnings are weak and oil prices, which are once again falling, have a big impact on the high-yield market. Oil company debt accounts for about 17% of the high-yield bond market, says Bianco.
In addition, Bianco says high-yield ETFs have an “outsized influence” on the underlying cash market because turnover in high yield ETFs account for about 20% of the turnover in the underlying cash market. In other markets, ETF turnover is about 1% to 2% of the turnover in the cash market. It’s like the “tail wagging the dog,” says Bianco. “High-yield ETFs are driving the market, not the market driving the ETFs. That has always been a risk with high-yield ETFs,” says Bianco. “High-yield traders are the only ones that will react to flows in and out of ETFs.”
Michael Contopoulos, head of Bank of America Merrill Lynch’s High Yield and Relative Value Strategy, disagrees with Bianco about where outflows from high-yield ETFs are going but he’s equally bearish about the market and has been for over a year.
Contopoulos says outflows from high-yield ETFs are making their way into the underlying cash market but not showing up in data about the secondary market because ETF investors are simply exchanging shares for the underlying securities. He is bearish on high yield because “fundamentals are poor … revenues weak, earnings growth bad and leverage high,” noting also that more companies are reporting impairment charges to write off goodwill.
In addition, says Contopoulos, the macroeconomic picture is sluggish, with China, Japan, Europe and even the U.S. reporting slow growth. “Risk assets don’t do well in those types of environments regardless of the rate picture,” says Contopoulos, noting that default rates are also picking up.
The bottom line: Investors are not getting paid for the risks in high yield at current yields between 7% and 8% and won’t be properly compensated until high yield yields near double digits, says Contopoulos. Until then, he suggests that investors choose duration risk, a measure of the sensitivity to changing interest rates, over credit risk and choose investment-grade bonds over high yield.
That is not the approach Goldman Sachs expects bond managers will take. Analyst Bridge Bartlett recently wrote that since 90% of actively managed high-yield debt funds have failed to meet or surpass their benchmarks this year, the search for yield will intensify, pushing fund managers into lower-rated, riskier assets.
Bianco suggests that investors instead buy gold, which he calls a “ ‘high-yield’ asset in a negative-rate world,” particularly for investors in Europe and Asia, where government bond yields are in fact negative. “A zero yield as gold has is a high-yield alternative when compared to $8 trillion’ worth of investment options in sovereign bonds,” says Bianco. “So we are really in an alternative universe where the high yield is now zero…”
U.S. investors, however, can collect yield from Treasuries and investment-grade bonds without facing the currency risk that could wipe out the income that foreign investors would otherwise collect.
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