It is no secret that we have grown cautious in the area of high-yield corporate debt, also known more commonly as junk bonds. Our concerns are not the underlying credit metrics of the companies and are not even really based on fears of systemic default risks in the near future. Our concern is over valuation as the yields and spreads for many junk bond issuers have become too low for comfort.
Last week we noted that spreads had widened out almost 30 basis points on the S&P Composite index that tracks the junk-rated universe, but they have since tightened up just a tad. It has not been enough to drive junk bond funds and ETFs handily higher. The options trading (yes there really is options trading on junk bonds) is indicating that more investors are growing cautious on the sector as well.
If you look at the SPDR Barclays Capital High Yield Bond (NYSEMKT: JNK) ETF, the December $40 put options saw a whopping 5,125 contracts trade hands, versus a prior open interest of 6,889 contracts. Most were buys, implying that at $40.13 some junk bond fund owner has taken out a hedge on what would be the equivalent of 500,000 shares worth of that ETF. The open interest was 5,051 contracts in the $39 puts and the open interest was 3,199 contracts in the $41 December puts.
The iShares iBoxx $ High Yield Corporate Bond (NYSEMKT: HYG) also has options, and we saw the $83 puts trade 2,500 contracts against an open interest of 2,721 contracts. The December $93 puts traded 1,090 contracts, versus a prior open interest of 1,085 contracts.
There are a couple of closed-end high-yield bond funds we track routinely as well. The BlackRock Corporate High Yield Fund V, Inc. (NYSE: HYV) still yields about 8.1%, but at $13.25 it has ticked down from a high of $13.58. The Dreyfus High Yield Strategies Fund (NYSE: DHF) yields more than 9%, but at $4.36 it has ticked down from a high of $4.70. These premiums also are still elevated as the premiums to net asset value on these two funds are almost 4% and more than 10% respectively.
What is interesting is that this may be a bubble, but it does not seem to be a bubble like the dot-com and tech bubble of 1999 to 2000. The options trading prices indicated that the move was protecting the position (or a bet that it would) against a drop of not quite 3% by December 21.
That being said, the QE3-driven low interest rate environment has created a larger premium in many junk bond and many other debt instruments. Can these pull back by 10% in price? Sure. If the prices of these funds fall another 5% or more then it may be worth looking at this sector again. Until then, spreads are tight and yields are getting too low for many issues against the inherent market risks in junk bonds. The most recent inflows have been new capital being forced to chase income. Unfortunately, if you look at a one-year chart in any of these ETFs and funds listed you will easily see how much these have risen in prices.
JON C. OGG