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Time to Exit Junk Bonds ETFs?

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Over the past several years, junk bonds ETFs were popular destinations for yield starved investors who didn’t really want a huge upgrade in duration risk. ETFs tracking this segment have enjoyed four years of robust returns and solid payouts, leaving many quite satisfied with their exposure.

But now, it seems that investors are pulling back their money from this fixed income asset class and are cycling their exposure into equities that enjoy strong market confidence. The investors have put more than $77 billion in stock funds during the first month of this year, the largest inflow since February 2000. Broad equity indexes are reaching new highs on the back of improving global economic conditions (read: 3 ETFs at the Heart of the Recent Rally).

As such, junk bond ETFs are seeing huge outflows of late as investors are hunting for income in the stock or MLP/REIT worlds instead. This chase and strong outflows have pushed down the yield on junk bonds to record lows. Junk bond yields recently fell below 6% for the first time (giving them a 500 basis points spread over U.S. Treasury bills).

As the yields are currently very low, it could be rough if interest rates go up. So, investors have started taking short positions in the high yield bond market, betting on the decline in the price of junk bonds and a spike in yields (read: Comprehensive Guide to U.S. Junk Bond ETF Investing).

Further, investors are worried about the outcomes in Italy, and a corruption scandal in Spain. An increase in European corporate default rates and low interest rates set by the Federal Reserve are also denting the bond market.

In this backdrop, the two most popular junk bond ETFs – iBoxx $ High Yield Corporate Bond Fund (HYG) and SPDR Barclays Capital High Yield Bond ETF (JNK) – have seen big outflows to start the year. In fact, their combined outflow for both so far in 2013 is over $1.1 billion, putting both into the bottom ten for flows this year in the fixed income world.

Both funds offer extreme liquidity and are the largest bond ETFs in the high yield bond space. Though both focus on intermediate term corporates, these are different from each other in many aspects (see more ETFs in the Zacks ETF Center).

HYG seeks to match the performance of the iBoxx $ Liquid High Yield Index, before fees and expenses, holding 736 securities in the basket. About 69% of the product’s holdings mature in less than 10 years, giving HYG an effective duration of only 4.03 years and average maturity of 4.45 years.

In terms of credit quality, the fund focuses on higher quality non-investment grade bonds, allocating just 12% of the portfolio to bonds rated ‘B’ or lower. Instead, ‘BB’ bonds make up nearly 38% of the portfolio while ‘B’ rated securities comprise the rest.

The ETF is also well spread across a variety of sectors. Consumer service makes up about 16% of the total, while oil & gas and financials comprise another 13% each (read: 5 Sector ETFs Surging to Start 2013).

The product has so far attracted assets worth $15.2 billion, charging investors a fee of 50 bps a year. It yields 6.08% in annual dividends, 5.06% in 30-day SEC yield and 5.54% in yield to maturity.

With AUM of about $12 billion, JNK tracks the overall performance of the Barclays Capital High Yield Very Liquid Index, charging 40 bps in annual fees from investors. The index includes fixed-rate, taxable, low-rated corporate bonds usually ‘BBB’ and below. The individual bond has more than $600 million in face value and remaining maturity of at least one year.

The fund is heavily exposed to the industrial sector with 86% of JNK and holds around 450 bonds in its basket. The product has a modified adjusted duration of 4.28 years and average maturity of 6.70 years. In terms of yield, the ETF pays out 6.25% in dividends, 5.21% in 30-day SEC yield and 6.25% in yield to maturity.

Bottom Line

HYG managed to stay flat, losing 0.2% in the year while JNK lost about 0.3% year-to-date (as of March 13). Thus, we see that the returns of junk bonds are diminishing and might go down further as we move further into 2013 (read: HYEM: The Best Choice in Junk Bond ETFs?). Both ETFs currently have Zacks Rank #3 or ‘Hold’ Rating, suggesting that the funds might not perform well over the next one year either.

This suggests that it may finally be time for junk bond ETF investors to start looking elsewhere for better options. At current valuations, stocks look much more attractive than bonds and could deliver better returns in the medium to longer term.

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