What are Junk Bond Inverse ETFs?
What Are High-Yield Bonds?
High yield bonds, referred to as “junk bonds”, are a class of corporate bonds with riskier credit ratings (BB and lower from S&P and Ba or lower from Moody’s). Bond ratings are determined by credit analysts using fundamental analysis to determine the ‘financial health’ of the corporation. Generally speaking, the riskier the bond, the higher the coupon payment it offers an investor to compensate for the additional risk. There are high yield and junk bond inverse ETFs to protect a position you may have in a bond fund in a retirement plan or brokerage account.
What’s the Concern for High-Yield Bonds?
Investors of all types have invested in junk bonds in recent years as the Fed’s zero interest rate policy, ZIRP, has made meeting required rates of return a challenge. Estimates put the U.S. high yield bond market around $1.3 trillion.1 High yield bonds provide greater yields (for greater risk) than most other classes of bonds. The difference in the yield received from riskier debt relative to ‘risk-free’ debt (U.S. Treasuries) is known as the spread. The high-yield market is arguably shakier than ever before with the prevalence of record numbers of ‘covenant-lite’ issues, bonds with scant investor protections. Corporate issuers get away with this because of the enormous demand for higher yields.
In fact, the demand for high-yield debt had gotten so strong, the average yield on high yield bonds in the Barclay’s U.S. Corporate High Yield Index made an all-time low record when it fell below 5% in 2013. To put this into perspective, that level is where the Federal Funds rate (often referred to as the ‘risk-free rate’) was right before the financial crisis. Unprecedented complacency to credit risks have priced junk debt as essentially risk-free on a historical basis. Also, deft marketing has allowed junk bond funds to advertise low default rates (a post-financial crisis low of just 1.42%, globally, in 2014) as a predictor of future default expectations. In fact, the post-financial crisis period of 2010-2014 saw the lowest 5-year period of junk bond defaults in modern history, according to Jim Reid of Deutsche Bank. Longer-term high yield default rates are around 5%, (more than triple the 2014 low rates). Further, this rate is skewed positively since the number of global speculative-grade issuers increased by almost 13% from 2013. This may be grossly underestimating risk.
The securitization of these bonds into junk bond ETFs has probably exacerbated this belief. Junk bonds are also grouped together into collateralized loan obligations (CLOs) and purchased by yield-starved investors which including pension funds, insurance companies and mom and pops. Financial innovations have made it easier than ever for investors to get into the high yield segment of the bond market, once only for professionals. There are now junk bond inverse ETFs to hedge several high yield mutual funds and a few very popular high yield bond ETFs (HYG and JNK) that have ballooned in asset size over the last decade. The pooling of these high-yield securities has apparently alleviated much of the concern for investors. But it certainly hasn’t mitigated the risk.
Another concern is that worried junk bond investors will try and exit these funds before funds freeze redemptions, like Third Avenue’s Corporate Opportunity Fund, producing a ‘run’ similar to what banks experience. There’s no guarantee that this couldn’t happen to This may have demand repercussions as well. In the future, junk bond fund may require investors to be accredited due to the (suddenly realized) risk involved and the regulatory backlash. Other illiquid bond funds have experimented with ‘gate fees’ when selling positions. On the ETF side, the underlying liquidity in these bonds is worrisome. Regulations have mandated that financial firms take on less risk meaning there may not be any buyers for these ETFs if the underlying components (the individual junk bonds themselves) can’t find bids. There’s no guarantee this couldn’t happen to high yield ETFs like HYG or JNK. Expect difficulty getting selling out of these positions in a crisis. Here is where junk bond inverse ETFs present an interesting idea if you have significant junk bond exposure.
Hedge High-Yield Exposure with Junk Bond Inverse ETFs
Junk bond inverse ETFs such as the ‘Short High Yield Corp’ Bond ETF (symbol ‘SJB’) aim to deliver the opposite return of the Markit iBoxx $ Liquid High Yield Index, on a daily basis. Some call it a hedge against HYG since they track the same benchmark. Still, SJB rebalances daily so it’s unlikely to be a perfect hedge over longer periods of time. Note that SJB’s top swap counterparty was Citibank (40%) as of September, 2015.
There are some alternative bond ETFs (also called ‘hedged ETFs’) that hold high yield bonds but hedge interest rate exposure by simultaneously shorting U.S. Treasury bonds. One example is ProShare’s ‘High Yield Interest Rate Hedged’ ETF (HYHG). But it tracks the Citi High Yield Index which only has duration of 3.91 years.2 With HYHG’s Treasury hedge, effective duration falls to slightly negative. These ETFs may be better than owning the high yield outright, but the main risks with junk bonds are credit and liquidity, not duration risk. Investment grade bonds are historically more interest rate sensitive (duration risk) and less credit sensitive.
If you’re worried about getting out of these high yield bond funds in the future, you might want to just sell them outright while you still can. Raising cash is the simplest and sometimes best hedge of all. Someday, an investment in a short-term cash equivalent ETF like BIL may yield more than junk debt did at its bubble peaks.