The red zone
While high yield bonds’ new issuance spiked, investors shied away from the bond market, as reflected in the weekly fund outflows of the chart below. There are two possible causes for these outflows. One is a fear of increased interest rates that may dampen the relative value of high yield bonds. Fed Chair Janet Yellen indicated in her speech on March 19, 2014, that the first possible interest rate hike to come in six months after the taper has concluded. Since high yield bonds have maturities that generally range from seven to ten years, these bonds will experience a greater change in price than shorter-maturity bonds and floating-rate bonds for a given change in interest rates. Plus, as we observed in Part 1 of this series, credit spreads have expanded on BB rated bonds by 4 basis points on the perception of higher default or credit risk.
After nearly six weeks of positive inflows, fund flows for the week ended March 28 declined by $651 million, to -$196 million. Year-to-date fund flows remained at 2.8 billion, compared to the $516 million inflows we saw over the same period the previous year.
With a net outflow, the trailing four-week average slipped to $348 million per week from $537 million last week and as high as $844 million per week three weeks ago.
Relevant ETFs: A reverse trend
Despite low demand, major ETFs that represent nearly 80% of the high yield bond market posted positive cash flows, as risk-taking investors seeking higher yields compared to the safety of principal value continued to bet on high yield bonds.
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 $161.8 million, indicating overall bullish market activity. 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 a three-year average return of 7.89%.
In line with HYG, another major high yield bond market ETF, the SPDR Barclays High Yield Bond (JNK), with total assets of $10.4 billion, posted a net inflow of $41.2 million last week. One-month net outflows were $80.5 million.
JNK 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%, this ETF yielded higher returns compared to HYG. The year-to-date return was 2.89%, while the three-year average return was 7.93%.
Both HYG and JNK prices appreciated last week as U.S. ten-year Treasury yields declined. Bond yields and prices are inversely correlated. Plus, the yield on the Bank of America Merrill Lynch U.S. High Yield Master II Index was down 0.04%.
In the short run, demand and supply in the high yield bond market may remain volatile. Issuers may continue to favor the low-cost borrowing environment. However, investors—particularly-risk averse investors—may become more cautious, given the expectation of an interest rate spike. Plus, many investors who’ve made their way from emerging markets (EEM) to the high yield bond market (JNK) in the past couple of weeks seem to be favoring international bonds on the news that the Chinese government may provide stimulus to boost its country’s growth. The iShares MSCI Emerging Markets (EEM) posted a net inflow of $116.3 million last week—a reversal of $11.3 million inflows and $83.4 million outflows in the last two weeks.
However, in the long run, on the backdrop 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. But an interest rate hike would negatively impact bond prices—particularly long-duration high yield bonds, as they tend to lose on higher relative value in inflationary conditions.
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