Investors are showing more signs of concern about some of the market's biggest sources of return, including tech stocks and emerging markets, but they have been moving big into another risk-on asset this quarter: high-yield bonds.
The iShares iBoxx High Yield Corporate Bond ETF (HYG) is No. 2 among all exchange-traded funds in the current quarter in new money from investors, only outpaced by iShares S&P 500 ETF (IVV), bringing in near-$3 billion, according to XTF.com. That's more than the asset-gathering behemoth $100 billion Vanguard S&P 500 ETF (VOO). In August the iShares high-yield bond ETF ranked seventh among all ETFs for monthly flows, taking in close to $1.4 billion.
Investors shied away from high-yield bond funds during the first half of the year — even with its big surge, iShares' HYG is still experiencing negative flows overall for the year. The reluctance to invest in junk bonds came despite the category's outperformance relative to other bond sectors, and the fact that it has been one of the only bond sectors generating positive returns this year.
The Merrill Lynch High Yield 100 Index has returned 1.95 percent year-to-date, and the Merrill Lynch Triple-C-Rated Index, tracking the lowest rated part of the high-yield universe, has returned 4.95 percent. HYG has returned 2 percent so far this quarter and 1.6 percent this year, through Sept. 4. The ETF that tracks the broadest bond market benchmark, the iShares Core U.S. Aggregate Bond ETF (AGG), is down by about 1 percent this year. Emerging market bonds, another source of high yields in the fixed-income market, are down significantly this year as fears of a debt contagion in those markets have pummeled emerging debt from Turkey to Argentina. The iShares J.P. Morgan USD Emerging Markets Bond ETF is down 6.5 percent this year.
Returns in traditional bond funds decrease as interest rates rise, and even as President Donald Trump recently challenged the Fed's decision to raise rates, many experts think there will be at least one to two more increases by the Federal Reserve this year due to strong economic data, including GDP growth and employment.
Returns in high yield, commonly known as junk bonds, can capture some of the upside of stocks and see increased returns even as interest rates rise. But high-yield bond funds don't offer the portfolio diversification that is typically provided by more traditional bond fund categories, such as treasurys or investment-grade corporate, due to their close correlation to stocks. That means they remain vulnerable to a market downturn.
Some more niche high-yield ETF plays are seeing even higher returns than the core iShares junk bond portfolio.
The move into high yield signals investor confidence in the economy and in the high-yield asset class in general, said Todd Rosenbluth, director of mutual fund and ETF research at CFRA Research. Continuous good news on corporate profits and other economic indicators, combined with relatively flat returns from short-term U.S. treasurys and negative returns from the closely followed 10-year treasury bonds, are driving investors to riskier bonds.
"When you see Treasury yields are low, people are more confident in taking a risk to get more yield," Rosenbluth said. "Investors in the past have been more fearful of credit vehicles, but we're in a risk-taking mode right now."
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