Will High-Yield ETFs Get Crushed When the Fed Ends QE?

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The U.S. Federal Reserve's quantitative easing (QE) and zero-interest-rate policies have had investors scrambling for yield for the past several years.

That's sparked a big rally in high-yield junk bonds, including a flood of assets into high-yield exchange-traded funds (ETFs) from institutional and retail investors unhappy with the low yields found in investment-grade and government debt.

Assets have poured into ETFs including the iShares iBoxx High Yield Corporate Bond ETF (NYSE: HYG) and the SPDR Barclays Capital High Yield Bond ETF (NYSE: JNK). The ETFs have offered investors good returns in terms of both yield and capital gains.

But with some betting the Fed is poised to end

QE, these investments could be carrying a lot more risk.

Even if the Fed ends QE by "tapering" off its asset purchases, the market is likely to react sharply to the Fed's decision. This could result in an unprecedented selloff in high-yield ETFs.

The Changing Risk Profile of High-Yield ETFs

The risk profile of high-yield ETFs is changing rapidly.

While individual investors use high-yield ETFs to increase investment income, there are a large number hedge funds and institutional investors taking advantage of the liquidity in these popular ETFs and ETF options to hedge positions in high-yield debt or to speculate on higher interest rates. High-yield ETFs can be sold short and the two ETFs mentioned above have actively traded options.

In recent weeks, the short positions in both JNK and HYG have increased sharply. The most recent data shows 8.76% of JNK shares outstanding have been sold short while the figure stands at 12.78% for HYG.

Looking at options, JNK March 41 puts had open interest of 10,353 contracts, equal to 1.03 million shares while the March 40 puts had open interest of 16,921 contracts or 1.69 million shares. Similarly, HYG has 255,939 March put contracts outstanding at strikes between 85 and 94, equal to 25.59 million shares.

Investors should remember that although the more popular ETFs are very liquid, some of the underlying bonds they hold are not.

Jeremy Stein, a Harvard economics professor who became a board member of the Federal Reserve Bank in May 2012, warned, "If relatively illiquid junk bonds or leveraged loans are held by open-end investment vehicles such as mutual funds or by exchange-traded funds, and if investors in these vehicles seek to withdraw at the first sign of trouble, then this demandable equity will have the same fire-sale-generating properties as short-term debt."

Translating from Fed-speak, if everyone wants to get out of a liquid ETF all at once, the ETF managers may not be able to sell the less-liquid underlying assets fast enough unless they offer them at bargain-basement prices.

The danger is that forced sales at below-market prices can create a panic situation similar to what we saw during the financial crisis of 2008. The price of a high-yield ETF and the value of its underlying assets could diverge, leaving investors to wonder what the ETF is really worth.

That degree of uncertainty in a market-traded instrument, such as an ETF, is a recipe for disaster.

Narrow Spreads a Cause for Concern

The yield on high-yield bonds and investment-grade bonds has narrowed to the point where many professionals think the junk bonds are overpriced. Investors are so concerned about improving yield that they are not paying enough attention to credit risk and reinvestment risk.

And the stretch for yield has some investors moving into emerging market high-yield debt.

But do you really want to own a portfolio of junk-rated Chinese corporate debt when the global economy hits a bump in the road? Today's spreads are simply not wide enough to justify that kind of risk.

Another point to consider: The rush to high yield has bid up the average price of a junk bond to 105.1, according to Barron's.

As a bond moves closer to maturity, the price moves closer to 100. That means investors will take capital losses on their principal over time.

In addition, most high-yield bonds have call provisions that allow the issuer to buy back the high-yield bond at a set price (usually around 105). If the issuer takes advantage of low interest rates to issue new, cheaper debt, the high-yield investor may not be able to replace the high coupon with a new bond that has a similar coupon.

These instruments have high yields for a reason - they are risky, especially when the Fed is hinting that it may soon stop supporting the long end of the yield curve through QE.

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