Apr 27th 2012, 12:11 by Buttonwood
PAUL Amery of Index Universe has a blog post drawing attention to the sudden surge of enthusiasm for junk bond ETFs, which have attracted $12 billion or so in assets over the last six months. Two funds, one from ishares, one from State Street, dominate the sector, with over $26 billion of assets between them. As a consequence, such funds have pretty diversified portfolios, the State Street version has 228 holdings, for example, and the top 10 comprise just 12% of the total.
Mr Amery produces some timely warnings about the phenomenon, noting that recent default rates may be artificially low and that the junk bond market is prone to spurts of illiquidity when yields soar and prices plunge. He is right, of course, but a lot depends on how investors are using the funds. Having 50% or more of your portfolio in such vehicles is clearly highly risky. But a 5-10% holding could easily be justified either as an alternative to equities in the "risk" section, or as a yield-kicker in the income section. After all, investors can lose money in equities too and history suggests buying Treasury bonds at 2% has not been a good deal.
One of the attractions of ETFs is that it allows small investors to allocate to asset classes that might previously have been out of their reach - owning an individual high-yield bonds is clearly too risky - at relatively low cost (expense ratios are 0.4-0.5%).
Of course, the broader point is that investors are being pushed into these high-yielding assets because of the policy of the Fed (and most developed world central banks) of keeping interest rates close to zero. Similar reasoning drove the enthusiasm for structured products that financed the subprime boom. Another bubble could be building here. But in his annual default study, Jim Reid of Deutsche Bank reckons that, for single B bonds, current yields offer investors a healthy margin over the average historical default premium. We have not yet reached the kind of low yields (or narrow spreads) that marked the credit boom of 2005 and 2006. Given their limited options, retail investors cannot really be faulted for adding a touch of high-yield to their portfolios.
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It's not just junk that is hitting the market. Look at all the Asian corporate "perpetuals" (not quite perpetual as they usually have a call), and the UK govt perpetuals.
A "yield kicker". That shows so much: the effect of a 5-10% or so allocation to higher yields is small but that is the marketing difference and thus the "push" toward adding risk. Then it seems safe so someone adds more to get an edge and then it turns out people have jumped further in than they let out, etc.
JNK went from 47 to 26 during the 08-09 bear. In the long run, heavy duty defaults tend to make aggregate junk bond total return about the same as investment grade corporates. In the short run, its best to buy them during bear markets, and wait for the economy to recover.
"Another bubble could be building here."
Indeed, capital is once again being misallocated by bank central planning of prices. This will lead to yet another future disaster for the west. The west cannot afford ubiquitous capital misallocation now that global competition for peak cheap oil/resources is here, and demographics are challenging.
The move to "junk" is largely a result of Federal Reserve (and other central bank purchases) of sovereign debt which has artificially pushed up the prices of government securities, pushing yields to unacceptably low levels as shown here:
http://viableopposition.blogspot.ca/2012/04/artificial-market-for-united...
Although owning a single bond is risky at least its a known & quantifiable risk. There is little/no visibility on these etfs.
If you compare at JNK and SP500 since March '09, JNK +25% SP500 +60%
Since March '08 JNK -12% SP500 +0%
Yield based on recent closing price JNK 7.3% SP500 +1.8%
NPWFTL Regards
Make that April instead of March. 3yr and 4yr charts I used.
NPWFTL Regards
You hedgefundguys blow funny looking bubbles.
In this blog, our Buttonwood columnist grapples with the ever-changing financial markets and the motley crew who earn their living by attempting to master them. The blog is named after the 1792 agreement that regulated the informal brokerage conducted under a buttonwood tree on Wall Street.
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