- Due to higher oil prices, ‘high yield’ bond yields are approaching historical lows while interest rates and inflation are increasing. Investors should be grateful for the amazing opportunity to unload.
- ‘High yield’ ETFs have grown from 0% to 10% of the total fixed income ETF market in less than 10 years.
- Apart from rising interest rates, illiquid ‘high yield’ primary markets in relation to the highly liquid secondary ETF markets signal potential Armageddon as there will be no buyers when the ETF trend reverses.
I usually look for investments where the risk is low and return is high as asymmetric risk reward situations provide the highest and safest returns. Today I’m going to do the opposite, discuss a high risk low reward investment. If you own or are attracted to higher yields, or want a short play, this article is for you.
What Is High Yield?
Many less sophisticated investors, don’t understand what high yield really means. ‘High yield’ is Wall Street’s way of selling junk to people by giving it a sexy name. Credit rating agencies rate sovereign and corporate debt by giving an A rating to those where the obligor’s capacity to meet its financial commitment on the obligation is extremely strong. Ratings go as low as ‘D’ for an issuer that is in default.
A high yield or junk bond, whatever you prefer to call it, has a credit rating below BBB. This means that these bonds are regarded as speculative with BB being the less speculative and C the most speculative with an almost certain future default.
Figure 1: S&P’s Credit rating definition with junk in red. Source: Standard & Poor.
According to the rating agencies ‘BB’ bonds don’t present risks if business conditions remain the same. Alongside higher yields, the low risk in a stable environment is what attracts investors to this kind of investments.
The economy is growing and many think everything will be well. But, do we have strong evidence that business conditions won’t remain the same? Yes, we do, and the evidence comes from the center of monetary power. Janet Yellen, the chair of the Board of Governors of the Federal Reserve System, has been warning us that interest rates will be higher in the medium-term. Higher interest rates mean lower bond values and increased defaults due to higher interest payments and refinancing difficulties. Apart from the obvious, there are other screaming risks.
‘High Yield’ Risks
The current Bank of America Merrill Lynch US high yield effective yield is 5.85% which is much better than the 10-year treasury yield of 2.47%, but don’t get greedy as high yields are close to their historical lows. This means that at the first sign of trouble, yields will shoot up like they did in 2015, 2011, 2009, and 2002.
Figure 2: ‘High yield’ vs. 10-year treasury yield. Source: FRED.
When high yields shoot up, bond values go down. Investors lost significant amounts in 2009, 2011, and at the end of 2015.
Figure 3: iShares iBoxx $ High Yield Corporate Bond ETF. Source: iShares.
The main issue is that you risk 20% or more for a yield of 5% which is close to historical lows with a small chance that it will go lower. If you aren’t convinced, let me elaborate a bit more.
Treasury yields have increased while junk yields have decreased due to higher oil prices creating a lower spread.
Figure 4: High yield (left & blue) and 10-year treasury (right & red) in the last 12 months. Source: FRED.
Any weakness in oil would immediately increase required junk yields as many of them are issued by energy companies exploring and exploiting shale.
Another issue is liquidity. When junk bonds get into trouble, nobody wants to touch them because there is a high risk of default. At the same time, investors will sell their ETFs on the open market, assuming liquidity. But if there is no counter party in the transaction, i.e. nobody wants to buy the ETF from you on the secondary (ETF) market, the ETF will be forced to unload bonds on the primary market in order to cover for the redemptions.
The problem is that the primary market can’t handle any kind of ETF fire sales because the liquidity on the primary ‘high yield’ markets is much lower than on the secondary ETF markets, especially since banks aren’t allowed to act as middlemen on junk bonds.
The trading volume on secondary ETF markets for the iShares iBoxx $ High-Yield Corporate Bond ETF is always 4 to 10 times higher than the volume on the primary ‘high-yield’ bond market covered by the same ETF.
Figure 5 Primary and Secondary Market Activity for the iShares iBoxx $ High-Yield Corporate Bond ETF. Source: Morningstar.
Liquidity issues don’t arise while the interest in ETFs is growing as there is more creation and demand from ETFs on primary markets. However, we haven’t seen what happens when there is a negative ‘high yield’ ETF trend as for the past 9 years, ‘high yield’ ETFs have only seen inflows.
Figure 6: Assets under management in High-Yield Bond ETFs. Source: Morningstar.
The current assets under management represent 10% of total assets in fixed income ETFs worldwide. 10% is a very scary percentage if things on bond markets reverse from the above described clean, decade long, growth trend. Unfortunately, with higher interest rates the trend is about to reverse. This will have an impact on other fixed income ETFs and could also spill over to stock ETFs and the stock market.
With ‘high yield’ rallying in the last few months, now is the perfect time to not be greedy and get out.
Yes, yields can go lower on fiscal stimulus and less regulation. On the other hand, the same positives would increase competition and lower oil prices. The situation is clearly asymmetric with high risk and low rewards. For a 5% yield, investors risk a 20% short term loss and a 50% medium to long term loss. This isn’t my kind of investment.