Must know: Why junk bond funds are in vogue again

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Secondary market activity in high yield debt mutual funds

High yield debt (HYG) mutual funds recorded their second consecutive weekly inflow. Net flows into junk bond (JNK) funds came in at ~$1.6 billion in the week ending October 31. Net flows into high yield bond (PHB) mutual funds are down by ~$2.3 billion so far in 2014. In contrast, net inflows into investment-grade (BND) bond funds and stock market (SPY) funds are up by $71 billion and $90.6 billion, respectively, year-to-date.

Part 5

Flows into high-yield bond funds reverse trend

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Inflows have been positive for the last couple of weeks for a number of reasons. Economic fundamentals are improving in the U.S. The gross domestic product increased by a larger-than-expected 3.5% in the third quarter of 2014. The labor market recovery has also surpassed expectations, with initial jobless claims trending to 14-year lows in October. Regional and national manufacturing and services sector surveys are also pointing to a growing economy.

Why U.S. Treasury yields affect junk bonds

These factors imply improved profits for firms and a better ability for corporate borrowers for discharging their debt obligations. This has reduced the spreads for lower-rated borrowers (please refer to the previous part of this series).

However, an improving economy also usually results in higher yields for Treasury securities. Firstly, it lowers demand for less risky assets. This was a key feature in Treasury auctions last week. Secondly, improving fundamentals make it more likely that the Fed will raise rates sooner rather than later. A rate hike would affect bonds across the credit and maturity spectrum, including both junk debt and investment-grade debt. Treasury yields rose last week, which affected the yields on high yield debt as well.

We’ll discuss the impact of October’s FOMC on the junk bond and leveraged loan markets in Part 8 of this series. The next part discusses why market conditions brightened for leveraged or senior loans last week.

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