Investors are dipping a toe back into high-yield ETFs. Here's what you need to know

Published Sun, Oct 9 20227:19 AM EDT

Jesse Pound @/in/jesse-pound @jesserpound

With equity markets swinging wildly and growing concern on Wall Street about a U.S. recession, investors have shown a curious interest in riskier parts of the bond market in recent days. As of Friday, the SPDR Bloomberg High Yield Bond ETF (JNK) had raked in $550 million of inflows over the past week, according to FactSet. And the iShares iBoxx High Yield Corporate Bond ETF (HYG) has done even better, with nearly $1.3 billion of inflows. Potentially, that marks the start of a reversal from this year's pattern, which has seen sharp outflows from high yield funds. Some of that is likely due to portfolio rebalancing at the start of a new quarter and yields easing from their recent highs, but it could also be a signal that investors are starting to nibble at risk assets again. "Is it a rebound? Perhaps. I know the yield part of it is nice for a lot of folks. … But I think the trajectory of those [flows] will be almost reliant on what stocks do here," said Todd Sohn, ETF strategist at Strategas Research. High yield bond funds have been beaten down this year, like the rest of fixed income. But their payouts have continued to climb, and that could present a nice reward for some more daring investors. Pros and cons One person who is bullish on the high yield space is Mark Carlson, senior investment strategist at FlexShares ETFs, a unit of Northern Trust. He said that investors should consider it as having risk closer to stocks but with a still juicy reward. "You get a lot of the equity premium carry through, but not all of the risk, not as much volatility," Carlson said. FlexShares' offerings include the actively managed High Yield Value-Scored Bond Index Fund (HYGV) and the ESG & Climate High Yield Corporate Core Index Fund (FEHY) . Those funds are off nearly -20% and -19%, respectively, in the year through Friday, but have large yields to help offset some of those losses. Carlson said that the high yield debt market, often called junk bonds, is not as risky now as it has been in prior periods of market stress. "The market has evolved into a higher quality of its former self. Some of that increase is due to the fallen angels of the Covid crisis ... but even if you strip away those fallen angels, the overall quality of the high yield market has been moving higher for several years if not decades," Carlson said. To be sure, growing concerns about bankruptcies can hurt high yield investors, even if they never materialize. One thing investors should keep in mind is that the spread between high- and low quality debt has barely budged this year, despite stepped up macroeconomic concerns. John Luke Tyner, a portfolio analyst at Aptus Capital Advisors, pointed out that funds like the iShares Interest Rate Hedged High Yield Bond ETF (HYGH) are posting only single-digit losses on the year, showing the decline for high yield bonds has been driven almost entirely by rising interest rates. "Credit risk has really held in. So ultimately, if you're buying credit risk at this point, you've got to really feel that companies are positioned well enough and are going to be able to sustain margins," Tyner said. Tyner added that a lack of new high yield issuance may be a signal that there is limited appetite for these assets among investors. "I think that gives you a sense of where the investor sentiment is on the space. It's down and out, but you haven't seen spreads widen, which is surprising," Tyner said. Carlson, however, said that he saw the lack of new issues in the pipeline as a good sign that companies were not going to have to take on the burden of higher interest rates in the near term. "We're going to be see an increase in maturities in '23 and '24 compared to 2022, but really there's not a major need for refinancing until you get beyond 2025," Carlson said. Other options Another way to get exposure to loans of smaller companies are business development companies, and the ETFs that track them. These firms invest in, or loan money to, smaller companies that, if they issued bonds, would likely have weak credit ratings. VanEck has a $465 million BDC Income ETF (BIZD) , which is down about 21% by price for the year but offers a dividend yield above 11%. Putnam launched its own entry in that space last week, with the actively managed Putnam BDC Income ETF (PBDC) . "We see an ongoing need for income for clients, and in the case of the BDC Income ETF that's a product that will yield anywhere from the 8 to 10% range," said Carlo Forcione, head of product and strategy at Putnam. One downside to investing in business development funds is the cost. Because the underlying companies are also essentially investment funds, investors are paying management for both the companies and the ETFs. The Putnam fund, for example, has a management fee of 0.75%, but a total expense ratio north of 10% when the fees for the underlying holdings are included. Forcione said that Putnam's active management could be worth that additional cost during an economic downturn. "And as the economy shifts and as, perhaps we're in recession or entering recession, having that ability to deploy active management ... is all the more important," Forcione said.