Junk Bonds Favored as BlackRock ETF Leads Flows: Credit Markets

Jun 03, 2014 12:11 am ET

June 3 (Bloomberg) -- Bond investors who see no end to the financial repression that’s pushed yields to record lows are piling even more money into notes of the riskiest companies, wagering that central banks will keep propping them up.

BlackRock Inc.’s exchange-traded fund that purchases the speculative-grade securities led about $686 million of deposits into high-yield ETFs in the last week, according to data compiled by Bloomberg. That’s more than 70 percent of all inflows into exchange-traded debt funds. The demand has depressed the average yield on junk-rated debt in the U.S. to an all-time low of 5.84 percent, Bank of America Merrill Lynch index data show.

Bond buyers are emboldened to embrace risk as Fed Chair Janet Yellen signals the central bank, which has held its interest-rate target near zero for more than five years, won’t increase borrowing costs for a “considerable time.” With the junk-bond default rate holding below its long-term average, the debt has gained 4.8 percent in 2014, exceeding the average annual estimate of nine banks.

“People recognize that the fear of rapid rate increases from the Fed is on hold,” Gary Herbert, a fund manager at Brandywine Global Investment Management LLC, which oversees about $44 billion in fixed-income assets, said in a telephone interview. “The Fed has signaled they are going to stay lower for longer and that has helped to anchor expectations, while there’s still a benign default outlook.”

Confounding Estimates

The rally in junk bonds would translate to annualized gains of about 12 percent, compared with 4.7 percent for loans made to high-yield companies, which have gained 1.9 percent this year.

Speculative-grade debt is rated below Baa3 by Moody’s Investors Service and less than BBB- at Standard & Poor’s.

The market’s move is overturning estimates at the start of the year by firms from Citigroup Inc. to Deutsche Bank AG and Morgan Stanley. They had predicted returns on junk bonds would be exceeded by similarly graded floating-rate obligations, which are seen as a shield against rising rates.

“The discrepancy in returns is mainly a product of unrealized rates expectations,” Barclays Plc strategists Bradley Rogoff and Eric Gross wrote in a May 30 report. “We expect loans to continue to underperform bond total returns until there is a substantial backup in rates.”

Yields Surprise

At the start of the year, the London-based bank predicted 3 percent to 4 percent gains for high-yield bonds in the U.S. and returns of 3.5 percent to 4.5 percent for loans.

The yield on the benchmark 10-year Treasury note has tumbled about 0.5 percentage point this year to 2.53 percent. At the start of the year, the median end-of-year yield forecast was 3.44 percent, according to estimates compiled by Bloomberg.

“We had expected interest rates to rise,” Tim Anderson, chief fixed-income officer at RiverFront Investment Group LLC in Richmond, Virginia, said in a telephone interview. “Junk bonds are going to do OK, and you will be clipping coupon in this environment. Given your alternatives in the fixed-income world, that’s one of the best things to do.”

Signs the economy is firming bolster the outlook for companies that are below investment grade.

Manufacturing expanded in May at the fastest pace this year as the Institute for Supply Management’s factory index rose to 55.4 from the prior month’s 54.9. Readings above 50 indicate expansion. The data is watched closely by financial markets as a gauge of the economy’s strength.

BlackRock ETF

That may signal a second-quarter rebound after U.S. gross domestic product declined 1 percent in the first quarter, its first contraction in three years.

High-yield mutual funds drew $2.1 billion of inflows last month, increasing the year-to-date additions to $5.2 billion, according to Lipper data compiled by Barclays. At the same time, investors yanked $1.3 billion from loan funds, the bank said.

BlackRock’s $13.7 billion iShares iBoxx $ High Yield Corporate Bond ETF, the biggest of its kind, has taken $539 million in deposits in the past week, the most among 327 fixed- income ETFs tracked by Bloomberg.

A Moody’s gauge of liquidity stress dipped to 3.7 percent in May, poised to decline for a third month and supporting its forecast for the default rate to stay below the historical average. The index falls when corporate liquidity appears to improve and rises when it weakens.

The New York-based ratings firm’s trailing 12-month global speculative-grade default rate was 2.4 percent in April, compared with an average of 4.7 percent.

Monetary Accommodation

Yellen’s May 7 testimony to the Joint Economic Committee of Congress signaled to investors the central bank is in no hurry to raise rates.

“A high degree of monetary accommodation remains warranted,” she said. Yellen identified unemployment at 6.3 percent as “elevated” and said that inflation is below the central bank’s 2 percent target.

In May 2013, when former Fed Chairman Ben S. Bernanke said the central bank could taper its stimulus measures, the remarks sparked withdrawals from junk-bond funds on investor concern that the Fed might curtail incentives to purchase riskier debt.

“When monetary policy is supportive, credit can perform well,” Herbert said. “The only exercise anyone gets these days is chasing yield.”