High yield exchange traded funds are reflecting investors’ growing concerns over the fixed income space, with short interest in these vehicle reaching a new record in February, according to data from IHS Markit.
According to the analysis provider, short interest in high yield debt ETFs has soared past the $7 billion mark, with short demand representing some 26% of the total borrowing demand for the underlying assets.
This demand has remained high in the latter part of the month, despite a rally in the asset category which erased some of the losses suffered earlier in February. Over the month, high yield bond ETFs have risen more than 1%, according to TrackInsight. Year-to-date, however, they remain in the red, down 0.8%.
High yield outflows
The asset class has also suffered elevated outflows lately, with ETFs tracking the sector suffering €4.7bn in cumulated outflows this year to 1 March, TrackInsight data shows (see chart below). Outflows have accelerated in the second half of February, with the week to 16 February seeing the sector shed some €2.8bn, significantly higher than its 12-week mean outflows of under €1bn.
One of the largest and most popular high yield exchange traded products, the iShares iBoxx $ High Yield Corporate Bond ETF, has seen cumulated outflows of €1.8bn so far this year (see chart). Meanwhile, Markit data shows the short interest on the $15bn fund reached an all-time high of 29% last Monday.
What is driving this short demand?
A key driver behind the short demand is investors’ desire to hedge against rising US 10-year Treasury yields, which have already jumped from 2.4054% on 1 January to their current level of 2.8115%, with investors fearing they could breach the 3% threshold, according to Bloomberg.
In the long-term high yield bonds do not tend to see the same negative impact from rising interest rates as other parts of the bond market and they have held up well in recent months, with the Bank of America Merrill Lynch US High Yield Total Return index falling only around 0.25% since the beginning of the year.
However, investors may be using ETFs to hedge against short-term pain, as well as to offset some of their long positions in the underlying market. According to Markit’s analyst and author of the report, Sam Pierson, the increase in short demand could therefore be attributed to the growing number of exchange traded products allowing a wider range of investors to gain short exposure to the asset class. Pierson added the trend reflects a general desire to have short exposure to high yield debt, rather than expressing a negative view on specific issues.
Strong US fundamentals
However, there seems to be little cause for concern on fundamental grounds, with strong growth in the US and inflationary pressures likely to prove supportive for junk bonds.
The International Monetary Fund (IMF) has recently raised its forecast for US economic growth in 2018 to 2.7% from a much lower rate of 2.3% projected in October, on expectations of a positive impact from Donald Trump’s huge tax overhaul.
Meanwhile, Moody’s has predicted a drop in the rate of defaults for the overall high yield market to 2% by January 2019, pointing to a benign environment for the asset category.
Additionally, according to Downtown Investment Advisory, high yield bonds are far more likely to decline in the event of a stock market crash than rising interest rates, which are already factored into market expectations, but will still fall less than the equity market itself in this event.