Relative to U.S. Treasuries, the credit spread for Standard & Poor's speculative-grade (BB and below) bonds was to 663 basis points on October 29, 14% higher than the spread at the beginning of 2015 and 20% above the five-year moving average. Following the Federal Reserve meeting last week, at which rates remain unchanged but the Fed indicated it might so initiate a rate-hike sequence in December, the yield on the 10-year Treasury at 2.14% at the end of October slightly lower than where it ended in 2014
According to Robert Polenberg, Vice President of Research, S&P Capital IQ, Leveraged Commentary and Data, as of late October, high yield bond volume is down 14% on a year-to-year basis. Meanwhile, the default rate hit a 26-month high of 2.5% in September 2015, but still is benign given the attractive yields. Polenberg also noted the cash flows for the high yield market turned positive in October, with $7.6 billion. S&P Capital IQ believes investors should have some high yield bond exposure as part of a well-diversified asset allocation strategy.
While the higher default risk might give investors in individual bonds pause, but we think those using ETFs and mutual funds receive the benefits of diversification. While some securities may face unexpected credit risk, funds spread around the risk across hundreds of issuers.
According to recent research from S&P Dow Jones Indices only 23% of high yield corporate bond mutual funds outperformed the Barclays High Yield index in the three-year period ended June 2015. On an equal weighted basis, the average high yield mutual fund lagged by 87 basis points on a three-year annualized basis. The average fund had a 1.1% expense ratio, which we think makes it hard for managers to keep pace with a benchmark.
SPDR Barclays High Yield (JNK), a $5.5 billion passive product, has a 0.40% expense ratio. The ETF sports a 6.94% 30-day SEC yield and trades with a $0.01 bid/ask spread. From a credit perspective, 48% of its assets were in bonds rated BB or equivalent, 36% were in B bonds and 11% were rated below B; S&P Capital IQ uses credit ratings info from Standard & Poor's Ratings Services and other independent ratings agencies.
Meanwhile, larger peer iShares iBoxx High Yield Corporate Bond (HYG) has a lower, but still compelling 6.75% 30-day SEC yield. HYG's asset base at $15 billion was aided by $2.3 billion of inflows in October. In exchange for a slightly less income, HYG has a more modestly risky credit profile. Bonds rated BB or equivalent were 51% of assets, while B (31%) and below B (8%) exposure was more limited. However, HYG's 0.50% expense ratio is 10 basis points higher than JNK.
For those investors that are concerned about the impact of rising interest rates, the average duration of 4.4 years for JNK might be too high. Three years ago, SPDR launched a companion ETF to meet this possible investor need.
SPDR Short Term High Yield (SJNK) has duration of 2.4 years and a 6.7% 30-day SEC yield. SJNK's credit quality is closer to JNK than HYG, though it has underperformed both this year in part because long-term yields have modestly decreased.