High Yield ETFs Take a Tumble

High-yield corporate bond ETFs tumbled today.

“This looks to be an exit trade from this asset class,” said Chris Hempstead, director of ETF execution services at WallachBeth Capital in a note, rather than a move to receive delivery of actual bonds.

Specifically, Hempstead’s desk has been very active in SPDR Barclays Capital High Yield Bond ETF (JNK), which dropped 1.3% to $38.19; iBoxx $ High Yield Corporate Bond Fund (HYG), which fell 1.4% to $87.59; PowerShares Fundamental High Yield Corporate Bond Portfolio (PHB), down 0.4% to $18.46, and SPDR Barclays Capital Short Term High Yield Bond ETF (SJNK), down 0.6% to $29.70.

After a redemption of about $725 million in the SPDR Barclays Capital High Yield Bond ETF last week, allegedly for delivery of actual bonds, Hempstead says the pace of selling in high yield ETFs needs to be closely monitored.

So far this year, each of these funds has seen a significant increase in assets, for a total of more than $6 billion year-to-date. With the iBoxx fund holding $14.8 billion in assets under management, the SPDR high yield ETF holding $11.2 billion, the PowerShares ETF at $943 million and $119 million in the SPDR short-term high yield, all the funds have about doubled their assets since January 2011, says Hempstead.

“We are watching closely to see how well the Street can absorb a short-term exit strategy from these funds,” said Hempstead in a note. “How would the fixed income world respond to a heavy and swift sell-off in an ETF product space that has seen a steady inflow of assets for almost 18 months?”

He adds the products have started trading at a discount to their respective NAV, which is not uncommon, but they have a tendency to trade at a premium for longer periods than at a discount.

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Fund Manager Says Sell High Yield and Emerging Markets

Frank Barbera, portfolio manager of the Sierra Core Retirement Fund, last week chatted with me about the market. Barbera runs a fund of funds that is very risk adverse and seeks to protect capital in a down market. During the 2008 crash, his fund fell just 2.8% vs. the 37% plunge in the S&P 500.

Over the last few weeks, Barbera has see such a decline in high-yield bonds that he’s exited all his positions and is now cutting back on emerging-market debt. He also sold all his holdings in emerging-markets equities, such as iShares MSCI Emerging Markets Index (EEM).

Barbera says anything linked to China has experienced a substantial decline, with emerging markets posting poor relative strength for the past six months. “There’s been no bounce,” he says, “We think Asia might slow down from both rising interest rates and higher-than-reported inflation.”

Because China’s currency is pegged to the U.S. dollar, he says our low interest rate policy is being exported to Asia and causing a lot of instability. Asia’s inflation problem and the enormous housing boom in Asia and Australia are a result of the U.S.’s loose monetary policy.

“With the reckless lending practices in those real-estate markets, we are preparing for a big downturn,” says Barbera. “Something is going to give and give big.”

He says the estimates for China’s bad loans could be as high as $5 trillion, which is nearly 100% of China’s GDP, sparking a deep recession and very hard landing. He adds that areas with strong real-estate markets, such as Australia , Hong Kong and Vancouver could soon deflate and see significant slow down.

He recommends getting rid of high-yield bonds and emerging-market debt and equities and says it’s time to move into short-term high-grade AAA corporate bonds.

Last month, I wrote about getting out of iShares iBoxx $ High Yield Corporate Bond Fund (HYG) and the SPDR Barclays Capital High Yield Bond ETF (JNK). Since then HYG has gained 2.2% and JNK 1%.

For short-term high-grade bond ETFs check out Barclays 1-3 Year Credit Bond Fund (CSJ), which has an expense ratio of 0.2%, and the SPDR Barclays Capital Short Term Corporate Bond ETF (SCPB), which charges 0.125%

Arnott Makes Fundamental Bond Index

Bloomberg recently did a profile of Rob Arnott, the father of fundamental indexing.

Arnott, whose Research Affiliates Fundamental Index, or RAFI, provided the foundation for the first ETF based on an fundamental index, the PowerShares FTSE RAFI US 1000 Portfolio (PRF) and others, is now working on making fundamental indexes for bonds.

Instead of valuing stocks based on price, as in a market-cap weighted index like the S&P 500, the fundamental index uses fundamental metrics such as cash flow, book value, sales and dividends to determine a companies valuation.

According to Bloomberg, the PowerShares FTSE RAFI US 1000 Portfolio posted annualized returns of 5.3% from its inception on Dec. 19, 2005, through May 9, beating the 3.2% return of the Vanguard 500 Index Fund, which tracks the S&P 500.

The new bond indexes will measure a borrower’s health, such as GDP, assets available to service debt, a nation’s land mass and energy consumption. PowerShares last year began using Arnott’s bond index in the PowerShares Fundamental High Yield Corporate Bond Portfolio (PHB). It returned 8.9% from Aug. 2 to May 9 vs. the 11.7% gain in the SPDR Barclays Capital High Yield Bond ETF (JNK). Let’s see how it does now that junk bonds appear to be peaking.

High Yield ETFs Look Especially Risky Now

Robert Powell of MarketWatch today says you should buy junk bonds, while Zero Hedge says he’s turned bearish on the sector.

I’m going to go with Zero Hedge because he makes a more compelling case, and in fact, if you didn’t see the headline on the Marketwatch story, you might think it was telling you to sell as well. In fact, the Marketwatch story’s big bull, Steve Huber, manager of the T.Rowe Price Strategic Income fund says, “To be sure, there is a scenario when investing in junk bonds might not so wise. If the U.S. growth slowdown proves not to be temporary and European periphery issues deteriorate further, the general selloff in risk assets could accelerate.”

It sure looks like that’s happening. And investors aren’t waiting around to see what happens. Powell says junk bond mutual funds saw $1.6 billion in outflows in just one week this month.

Meanwhile, ZeroHedge is down on the entire high-yield market, especially Greek, Irish and Portuguese bonds. However, he is particularly bearish on the iShares iBoxx $ High Yield Corporate Bond Fund (HYG) and the SPDR Barclays Capital High Yield Bond ETF (JNK).

He says if the junk bonds continue to see heavy outflows “it will be hard for high yield to maintain current prices, particularly given how illiquid it currently is.” He says you can tell how illiquid they market has become by the haircuts both funds took last Thursday, when HYG fell 2%. As trading volumes in junk bonds fell and bid/ask spreads widened, institutional investors sold the ETFs rather than the actual bonds. With the liquidity at an extreme low, he says cut your high-yield risk, and is on the verge of shorting the ETFs.