Junk Investors Prefer Short-Term as Long-Term ETFs Fade

Investors in exchange-traded funds that buy junk bonds are shifting into shorter-maturity debt that’s less vulnerable to the Federal Reserve’s withdrawal of stimulus measures.

Money managers have pulled $2.2 billion this year from BlackRock Inc.’s $13.1 billion ETF that buys speculative-grade bonds, the most among more than 300 fixed-income ETFs tracked by Bloomberg. At the same time, investors have been adding cash into Pacific Investment Management Co.’s short-duration ETF that purchases notes maturing in five years or less, with its assets swelling about 34 percent to $4.9 billion, according to data compiled by Bloomberg.

Buyers of the debt are shielding themselves from a drop in prices that may be triggered by the Fed paring its purchases of Treasuries and mortgage-backed securities that helped fuel the junk-bond boom. The high-yield notes, traditionally favored during a period of rising interest rates, are seen more susceptible this time with the premium paid to hold on to them over government debt at a seven-year low.

“The warning sign is flashing with the Fed winding down” its asset buying, William Larkin, a money manager at Salem, Massachusetts-based Cabot Money Management, said in a telephone interview. “This is the time to exit the building, even if it’s a false alarm. We get too used to this low interest-rate environment right before it chops your head off.”

The extra yield investors demand to own speculative-grade securities rather than government bonds dropped to 364 basis points last month, the least since July 2007, Bank of America Merrill Lynch index data show. A basis point is 0.01 percentage point.

Yield Gap

The average yield of 6.9 percent for bonds coming due in more than 10 years compares with 5.1 percent on notes maturing in less than five years, Bloomberg bond index data show. That gap was 2.3 percentage points at the start of the year.

ETFs allow buyers to invest in junk bonds without having to directly buy or sell the debt. The funds sell shares linked to the value of a portfolio of assets. When investors seek to pull money from the ETF, the fund delivers securities to dealers to sell into the market to facilitate the redemptions. When the funds receive deposits, they sell shares to the dealers in return for a basket of assets that seek to track or exceed returns on a designated index.

The share creations in these funds may also reflect short-selling, or borrowing shares and selling them, with the goal of profiting by repurchasing them later at a lower price.

Risky Trade

The migration toward short-term notes, which started earlier this year, has been tempered with Fed Chair Janet Yellen playing down rate-rise projections. Investors in long-term bonds, emboldened by those comments, have reaped returns of 9.1 percent this year, more than four times the 2 percent gains on the shorter-maturity debt.

“People who might be in the longer term stuff might be correct right now but it’s a high-risk trade,” Larkin said. “This market isn’t too liquid when there’s any pop.”

The compression in spreads, or the reduction in premium for purchasing long-duration debt, is a reason why investors may choose to swap into the short-term bonds, according to Larkin.

The Federal Open Market Committee on April 30 reduced the Fed’s monthly bond purchases to $45 billion, its fourth-straight $10 billion cut, putting the central bank on course to end this stimulus measure by the end of the year. The Fed plans to keep interest rates, which have been anchored near zero, at the same level for a “considerable time” even after the bond purchases end, the FOMC said in a statement.

Yields on Treasuries, or government benchmark debt to which most corporate bonds are pegged, have pared the increase that started a year ago. The 10-year U.S. government bonds yield 2.6 percent, compared with 3 percent at the beginning of 2014.

“Treasury yields are low and the consensus expectation is that they will rise at some point,” Citigroup Inc. strategists led by Stephen Antczak wrote in a May 1 report. “The problem is that mutual fund holdings of corporate bonds are higher now than they have ever been. And if outflows occur in response, they could overwhelm dealer balance sheets.”

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