Will investors prefer investment grade over high yield in 2014?

Part 3
Will investors prefer investment grade over high yield in 2014? (Part 3 of 7)

Short interest ratio shows record spike for high yield bond ETFs

Short interest ratio

Bond prices are inversely proportionate to yield. This implies that bond prices decline when yields increase and bond prices increase when yields decline. Investors would take a short position in a bond fund when they expect yields for the fixed income securities included in the fund to rise, which would reduce their prices in the future. This would enable short-sellers to purchase the shares of the fixed income ETF at a lower cost in the future and profit on the difference between the selling and purchase price.

Part 3Enlarge Graph

Impact of the Fed’s tapering program and interest rate risk

The Fed has reduced its monthly bond buying program by $30 billion per month, to $55 billion per month, by announcing reductions of $10 billion each in the FOMC meetings held in December 2013, January 2014, and March 2014. A reduction in monthly bond purchases would, other factors remaining constant, reduce market liquidity and cause bond yields to increase. This would raise interest rates across the bond quality spectrum, affecting both non-investment grade bond ETFs like the SPDR Barclays Capital High Yield Bond ETF (JNK) and the iShares iBoxx $ High Yield Corporate Bond ETF (HYG), and investment-grade bond ETFs like the Vanguard Total Bond Market ETF (BND).

Top holdings in HYG include Sprint 144A 7.875% (S), with 0.57% of total assets. HYG has clocked total returns of 26.2% over the past three years and 3.23% year-to-date (to February 28). The short interest ratio for HYG increased to 7.746x on February 28, 2014—the highest since September 14, 2007.

JNK has provided total returns of 7.87% over the past year and 25.72% of total return over the past three years. The year-to-date total return (to February 28, 2014) for JNK is 2.89%. The short interest ratio for JNK increased to 7.051x on February 28, 2014—the highest in the ETF’s history, since its inception in November 2007.

Read on to Part 4 of this series to find out how credit risk will affect returns on high-yield bond ETFs and their short interest ratios.

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