Junk bond ETFs have been drawing attention lately on investors’ drive for higher yields in the ultralow rate interest environment. Most of the developed economies are pursuing ultra-low and even negative interest rate policies while yields on the benchmark 10-year U.S. Treasury notes slumped to record lows in early July, especially due to apprehensions over the Brexit fallout.
Investors should note that despite the recent spurt in the U.S. stock market and investors’ renewed optimism over risky assets, the yield on the benchmark 10-year U.S. Treasury notes was just 1.57% as of July 26, 2016. Global growth worries mainly pushed bond yields down, prompting investors to bet on junk bond ETFs in search of steady current income.
Thanks to this sentiment, junk bond ETF iShares iBoxx $ High Yield Corporate Bond ETF (HYG - Free Report) gathered as much as $2 billion of assets from June 1 to July 20, 2016 (as of etf.com). But have you ever considered how risky this investment is?
Underlying Risk Factors
According to investment researcher Morningstar, the average emerging-markets bond ETF yields 3.8%; the average high-yield ETF yields 5.5% while the 10-year U.S. Treasury note yields below 1.6% and the Barclays U.S. Aggregate Bond Index is offering under 2% in yields (read: Yield Hungry Investors Gobble Up EM Bond ETFs).
Now since we all know that higher yields can only be achieved by investing in longer term and in poor-quality fixed income securities, investors should never ignore the risks tied to this highest-yielding junk bond category. While long-term bond yields are associated with interest rate risks, junk bond ETFs are exposed to default risks.
For the high-yield bond market, the health of the energy sector is crucial. U.S. energy companies are closely tied to the high-yield bond market, comprising about 15% of junk bond issuance, as per CNBC.
Oil price rallied to the $50 level in recent times after seeing a massive drop early this year, giving investors reasons to be bullish on the junk bond ETFs’ space. But now with oil again falling to almost a three-month low amid supply glut, tension might build up over the junk bond ETFs (read: 5 ETFs for Those Who Believe the Oil Rally is Over).
Plus, thanks to the latest volley of upbeat U.S. economic data, it won’t take much time for market watchers to bring rate hike talks back on the table. If the Fed tightens policies in the near term, yields on the Treasury notes will eventually rise, thereby fading the sole lure of the high-yield bonds see all Junk Bonds ETFs here).
Adding to these risks, junk bonds are often considered equivalent to stocks. Agreed, U.S. stocks are now in a high-flying mode, but may lose momentum if earnings weakness prevails in the coming days. If such a situation arises, junk bonds may recede on risk aversion.
Where to Find Relative Safety & Decent Yield?
So, it is better for edgy investors to play the junk-bond ETFs space with a little caution. When investment-grade corporate bond ETFs can provide investors over 3% yield along with stronger possibilities of steady capital gains, jittery investors may avoid adding on to their risks in an environment of below 1.60% U.S. 10-year Treasury yield.
Below we highlight a few choices among investment-grade corporate bond ETFs (read Time for Investment Grade Corporate Bond ETFs?).
Vanguard Long-Term Corporate Bond ETF (VCLT - Free Report) – Yields 4.09% annually
iShares iBoxx $ Investment Grade Corp Bond ETF (LQD - Free Report) – Yields 3.22% annually
Vanguard Intermediate-Term Corporate Bond ETF (VCIT - Free Report) – Yields 3.16% annually
Fidelity Corporate Bond ETF (FCOR - Free Report) – Yields 3.15% annually
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