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Anxiety Starts to Grow in Junk-Bond Market

Money pulled from high-yield-credit ETF at fastest pace since 2016 as investors hedge with options

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The Federal Reserve’s recent moves to raise interest rates and a climb in Treasury yields could prompt investors to shed riskier debt. Photo: chris wattie/Reuters

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By

Gunjan Banerji

Oct. 4, 2018 8:00 a.m. ET

Investors are getting antsy about the junk-bond market.

They pulled money out of the biggest exchange-traded fund that bets on high-yield credit during September at the fastest pace in almost 2½ years. And some investors are snapping up protection, buying options contracts that would help them offset losses if junk debt sells off.

Returns from high-yield bonds have already been muted this year, especially relative to markets like stocks. The Bloomberg Barclays U.S. Corporate High Yield index has returned 2.8% in 2018 as of Tuesday, while the S&P 500 has returned 10.9%, including dividends.

But while Treasury yields have climbed to near seven-year highs and the average speculative-grade bond yield has edged up, the difference between the two has also fallen to the lowest level in a decade, FactSet data show. A narrower spread indicates investors are willing to take less compensation from riskier companies—a sign they believe the broader economy will be healthy enough for these companies to make good on their debt.

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Slim GapAverage high-yield bond spread to TreasurysSource: Bloomberg Barclays, FactSetNote: Option-adjusted

The resilience of high-yield credit at a time when the Federal Reserve has been raising interest rates is leading to growing apprehension among some. Lale Topcuoglu of JO Hambro Capital Management said she has pulled back from the riskiest bonds in the junk market and opted for slightly higher graded debt.

“As you look forward to year-end, we are a little cautious.” said Ms. Topcuoglu, head of credit at JO Hambro. “This is the mental tennis game.”

Higher yields from Treasurys could eventually prompt investors to dump riskier debt, some analysts say. Government bond yields have climbed higher recently with little reaction from junk bonds—a contrast to earlier this year, when Treasury and high-yield credit yields both rose.

Meanwhile, investors pulled over $2 billion from the iShares iBoxx $ High Yield Corporate Bond Exchange-Traded Fund, known as HYG, in September, the most in a single month since May 2016—shortly after plunging oil prices led to widespread selling in junk bonds, FactSet data show.

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The $16 billion bond ETF is a small slice of the high-yield bond market, which tops $1 trillion, but its ease of trading and popularity among retail investors can offer clues to shifting sentiment. The shares are little changed so far this year, down 1.4% as of Tuesday.

To be sure, there have been false alarms in high yield before. The junk-bond market has held steady as interest rates around the world have for the most part remained low, pushing investors into the higher-yielding debt. HYG’s outflows in September came after two straight months of money going into the fund. Still, investors have pulled roughly $1.6 billion from the fund in 2018 after taking out about $500 million last year, FactSet data show.

Peter Cecchini, New York-based chief market strategist at Cantor Fitzgerald, said the junk bond ETF is one of the few areas showing signs of investor anxiety.

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There has been little hedging activity in other risky assets, like U.S. stocks, which are in the midst of the longest bull market ever. In the equity market, investors have actually been using bullish options to chase further gains, analysts say.

An options measure called skew has risen over the past month for HYG, Trade Alert data show. That means bearish contracts have become relatively more expensive—a sign investors are willing to splurge on protective options even if they’ve become pricier. DISCUSS THIS

Investors are also purchasing options that would only pay out if HYG’s price fell far below its current level—a sign they are hedging against a potential catastrophic event that could hurt their portfolios, according to Mr. Cecchini.

Among the biggest positions in HYG are options that pay out if the ETF falls about 5%, Trade Alert data show. This week, the number of positions in contracts that pay out if the ETF slumps 13% also increased, the data show.

“It’s fear of an unknowable tail event,” Mr. Cecchini said.

—Sam Goldfarb contributed to this article.

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