But alarm bells also have been sounded ahead of the recent move by ETF investors into the space, with some market experts focused on an unusually low level of bond supply propping up the recent high-yield performance. Second-quarter junk bond issuance hit its lowest level since 2010 in the second quarter, according to Bloomberg data. July high-yield bond issuance was the slowest since 2008.
In May, Moody’s warned of a “particularly large” wave of junk bond defaults coming. The rating agency noted that even though default rates are low now, since 2009, the level of global nonfinancial companies rated as speculative, or junk, has surged by 58 percent, to the highest proportion ever. In dollar terms that translates to $3.7 trillion in total junk debt outstanding.
Lisa Coleman, head of global investment-grade corporate credit at J.P. Morgan Asset Management, said investors were nervous during the first quarter, when the S&P 500 had its first quarterly loss since 2015 and the DJIA was down nearly 2 percent. Even with this week’s jitters, the market has rallied since the first quarter, with sizable gains in the S&P 500 and Russell 2000, and coupled with strong GDP and employment numbers, investor anxiety has eased. She added that recent stability in treasury bond rates has likely made investors more comfortable investing in all bonds, including high-yield bonds.
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“Treasurys have stayed at a pretty stable range over the past few months, and I can’t help wondering if that’s what is drawing them to high yields,” Coleman said.
There is also likely a bit of performance chasing on the part of investors. “I think there’s also a lot of people looking in the rearview mirror and seeing there have been pretty good returns for high-yield funds,” she said.
Investors need to be aware of the potential dangers of investing in high-yield bonds. There is a higher credit risk than with funds investing in lower-returning corporate bonds, so investors need to be aware of the risk of default and potential subsequent harm to their portfolios.
“Companies that have stretched balance sheets have them for a reason, so there are risks that need to be accepted,” Rosenbluth said.
Lou Stanasolovich, president of Legend Financial Advisors, said there is an added risk of investing in junk bonds through ETFs, and he prefers to have his investors exposed to this income play through traditional mutual funds. That’s because ETF trading requires monitoring of bid/ask spreads, and in more narrow areas of the market, the spreads can create higher trading costs.
A traditional mutual fund is bought and sold at net asset value. ETFs trade with bid/ask spreads, like stocks, and those spreads can move around based on the volume of trading in the ETF and underlying securities. The narrower the bid/ask spread, the lower the cost to trade. In a high-yield sell-off, individual investors may lack the same knowledge as institutional investors to trade ETFs at the best price.
That’s not a concern with traditional funds. “When you want to sell, it’s the mutual fund’s problem, not the investor’s,” Stanasolovich said.
—By Mike Schnitzel, special to CNBC.com