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Why refinancing deals crowded the high yield bond market

Part 3
Why refinancing deals crowded the high yield bond market (Part 3 of 6)

Why high yield fund flows stayed positive 6 weeks in a row

Weekly fund flows

Weekly fund flows are a great momentum indicator that can signal changes in investor sentiment. When fund flows increase, they suggest the institutions and individual’s investment in high yield debt have increased, and vice versa.

High yield bond flows last week posted the straight sixth week of positive inflows, though the pace was lower than the previous week, possibly because the Fed signaled a rise in interest rates. Fed chairwoman Janet Yellen gave her first press conference on March 19, 2014, and signaled a potential rate hike six months after the quantitative easing program concludes—which is expected to fall by October or November 2014.

HY funds flowEnlarge Graph

Fund flows for the week ended March 21 were $455—$118 million less than the previous week’s $573 million inflows. Year-to-date fund flows are much higher, at $3.0 billion, compared to the $482 million inflows seen over the same period in the previous year.

Relevant ETFs

In line with the high yield bond market, the iShares iBoxx $ High Yield Corporate Bond (HYG), with total assets of $13.5 billion, posted a net inflow of $72.6 million last week. One-month net inflows were $193.7 million, indicating overall bullish investor sentiment. The ETF has a gross expense ratio of 0.50% and tracks the performance of the iBoxx $ Liquid High Yield Index.

HYG, with top holdings in the Sprint Corporation (S) and Hospital Corporation of America (HCA), has delivered a year-to-date return of 2.72% and three-year average return of 7.89%.

On the other hand, another major high yield bond market ETF, the SPDR Barclays High Yield Bond (JNK), with total assets of $10.4 billion, posted a net outflow of $16.2 million last week. One-month net outflows were $52.1 million.

The JNK ETF tracks the performance of the Barclays Capital High Yield Very Liquid Index for high-yield (Ba1/BB+/BB+ or below) rated bonds. At a lower expense ratio of 0.40%, the ETF yielded higher returns compared to the HYG ETF. The year-to-date return was 2.89%, with three-year average returns of 7.93%.

Both HYG and JNK ETF prices appreciated last week, despite a rise in U.S. ten-year Treasury yields. Plus, the yield on the Bank of America Merrill Lynch U.S. High Yield Master II Index was down 0.02%.

Outlook

Returns on high yield bonds are a combination of credit risk and interest rate risk. On the backdrop of the Fed’s tapering as a result of the strengthening economy, high yield bond issuers’ fundamentals are expected to improve. This in turn would reduce the credit risk associated with issuers, resulting in a contraction of credit spreads. A contraction of credit spreads is a positive sign for high yield bonds, as investors perceive a lower risk of default. At present, default rates are trading at a historically low average of 2.2%. In the third quarter of 2009, high yield bonds’ default rate reached as high as 13.4%.

However, rising interest rates will have a negative impact on bond prices—particularly long-duration high yield bonds, as they tend lose on higher relative value in inflationary conditions. But short-duration high yield bonds (SJNK) may not be highly affected by interest rate spikes.

Also, from an emerging market perspective, high yield bond markets may continue to capitalize on problems in China and Russia. Recent market activities have suggested a cautious outlook on emerging markets, which have continued to sell off heavily. Investors may wish to limit their exposure to emerging market bonds issued in U.S. dollars, as reflected in the iShares J.P. Morgan USD Emerging Markets Bond (EMB) and PowerShares Emerging Markets Sovereign Debt Portfolio ETF (PCY). Both ETFs have posted negative returns over a one-year period compared to the positive returns posted by high yield bond ETFs.

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