High yield bond ETFs are paying hot yields. Proceed with caution
Hopes for a soft landing are alive, and investors are tiptoeing into a corner of the market that offers sweeter yield in exchange for greater risk. High yield mutual funds and exchange traded funds saw inflows of $1.9 billion in July, Barclays said, citing Lipper data. That recent interest comes amid total 2023 outflows of $11.2 billion, the data showed. High yield bonds are corporate issues that are rated below BBB, meaning they have a higher risk of default compared to their investment-grade counterparts. Investors betting on a soft landing for the economy just received further validation Thursday, with July’s consumer price index coming in below expectations. The inflation metric rose 3.2% on an annualized basis, versus economists’ estimates for a 3.3% gain, per Dow Jones. Still, corporate default worries remain. Fitch Ratings anticipates the U.S. high-yield default rate will trend higher, ending 2023 in a range of 4.5% to 5%. This would be the result of higher interest expenses and tighter lending conditions. Others remain upbeat on the asset class despite the risk. “Management teams have been focused on preparing for higher interest rates and a potential recession for over a year now,” said Bill Zox, portfolio manager for high yield and corporate credit strategies at Brandywine Global. He noted that high yield issuers have had access to capital, too. “I think the bet in high yield is that it’s not going to be a repeat of the global financial crisis or the tech telecom bubble in the early 2000s,” Zox said. “It’s going to be a more benign environment.” A very selective play Leaping into high yield can pay – if you have a stomach for the volatility and are comfortable with a corner of fixed income that can behave like equities. For instance, the SPDR Portfolio High Yield Bond ETF (SPHY) posted $924 million in flows this year, with $588.3 million of that amount coming in the past month, per FactSet. The 30-day SEC yield is 8.39%. It suffered in 2022, posting a return of -10.6%, but it’s toting a return of more than 6% this year. Professional investors in the space are picky about how they pursue this income. “Risks are asymmetric in high yield,” said Bryan Novak, senior managing director of Astor Investment Management. “When we are in junk and high yield names, we prefer loans – more senior loan positions rather than high yield.” These senior loans are secured by the issuer’s assets and they’re senior in the company’s capital structure – which puts holders of these loans ahead of bondholders in the event the company goes out of business. The loans also tend to be short duration, meaning they have less price sensitivity to changes in interest rates. Individual investors can’t participate directly in the senior loan market, but they can play it with ETFs. The Invesco Senior Loan ETF (BKLN) , for instance, has an SEC 30-day yield of 8.35% and an expense ratio of 0.66%. Novak added outside of high yield loans, the firm’s other big fixed income play is higher quality investment grade bonds. He highlighted the iShares 5-10 Year Investment Grade Corporate Bond ETF (IGIB) , which has a 30-day SEC yield of 5.49% and an expense ratio of 0.04%. Meanwhile, Brandywine’s Zox says energy is looking good in the high yield space. “The equities have been weaker after a fantastic 2022, but from a bond perspective, those companies have very solid credits,” he said. He also likes nonbank financials, noting that even as consumers have struggled with high inflation, they remain employed. Approach with caution Investors comfortable with the additional risk can set aside a small portion of their portfolio for high yield. “Dipping your toe in makes sense from an allocation standpoint,” said Bill Ahmuty, head of the SPDR ETF fixed income group at State Street. “ETFs are a great way to do it because they’re diversified instruments and if you’re not sure about the high yield market, you want to eliminate some idiosyncratic risk.” A 3% to 5% allocation toward high yield could be reasonable for investors who want to incorporate some of these assets, said Lawrence Gillum, chief fixed income strategist at LPL Financial. However, the firm has been recommending that clients’ fixed income allocation be in core bonds, short duration and investment grade issues. “We don’t think taking a heroic position [in high yield] makes a whole lot of sense in our view,” he said. -CNBC’s Michael Bloom contributed to this story.
