Over the past several years, the Federal Reserves policy has forced investors to take on additional risk in order to achieve acceptable yields on their investments.
Since 2008, yields on CDS have decreased from 5 to 6 percent down to just above zero. This has caused investors to buy riskier and lower quality investments to try to maintain their incomes. In addition, since 2008 the credit markets have been fairly stable. This has resulted in people being complacent. Investors need to start paying attention to what is taking place within today’s credit markets, particularly within the high-yield bond arena.
Declining commodity prices has pushed some high-yield bonds in the direction of default. Over the short term, it doesn’t appear that the pressure on the mining, metals and energy sectors are going to see relief. Mining, metals and energy issues comprised a large percentage of the the total high-yield bonds that are available.
For 2015, high-yield funds have experienced a negative returns, however things may get a lot worse. The yields that are coming from those funds are seen by investors as attractive, as they are in the 7 to 8 percent range.
This yield appears to be attractive. However, what isn’t obvious is that the market has bifurcated. Yields on commodity and energy companies have increased to around 12 percent. The rest of the market is around 5.5 percent. A 12 percent yield is an indication of a high expectation that energy and commodity companies will default. Last year over $1 trillion in bonds were downgraded by Standard and Poor’s, and the pace seems to be increasing.
Investors, on the surface, would be attracted naturally to an 8 percent yield. However, if the energy arena worsens by many of the companies defaulting, it could result in investors getting a rude awakening and leaving them with large losses.
As of June 30, over 80 percent of oil producing companies’ cash flow was being used to service their outstanding debt – leaving very little money for funding operations. Oil during this time was still trading at a price of well over $50 per barrel. With oil currently trading in the $30 range, this situation has become even worse.
Adding to these challenges, numerous high-yield bonds aren’t liquid. Quite likely individual investors own high-yield bonds via an open-ended mutual fund or ETF. It is generally believed that if they want to sell it will be easy for them to do, which is true.
However, the thing that isn’t obvious usually is what can take occur to a fund’s price in an environment that causes people to be fearful. If concerns over the credit cycle worsens and investors start to sell their funds in big quantities, the prices of the bonds within the funds may significantly drop, even there aren’t defaults. When fund investors are selling, the manager of the fund must raise cash in order to pay the redemption out. The manager also needs to sell a portion of the holdings of the fund.
The corporate bond market is comprised of thousands of various issues, with many of them not trading regularly. Whenever the fund manager has to sell, a buyer needs to be found. During a time when there is high-selling pressure, buyers have a tendency to offer either no bids or low-ball bids.
Keep in mind, the fund manager needs to sell, at almost any price in order to meet the fund’s redemption request. This liquidity issue might be a bigger risk than the default issue is for high-yield bonds.
One thing that is quite clear: mining and energy companies are currently facing increasing and ongoing headwinds. Given all of the problems they are facing, there are real reasons why the yields on mining and energy bonds have increased so much. Investors owning high-yield funds need to have a good understanding of the exposure these funds have with those sections – as well as the risk of large redemptions from other holders or defaulting bonds.
I don’t believe that this is the time to taking too much risk in a high-yield market. However, a different approach is offered by some funds to high-yield exposure. Consider:
The Fallen Angel High Yield Bond ETF From Market Vectors(ANGL): The holding of this fund are junk bonds that were issued originally having an investment grade rating. The fund’s credit composition consequently is better compared to other funds. Its SEC yield is at 5.9 percent. Although some current income is sacrificed, we think that the fund’s overall superior credit profile can serve investors very well. During fearful times, it isn’t likely that it will avoid the volatility that is inherent in high-yield funds. However, the fund’s credit quality should help to minimize any negative impacts from large defaults.