Junk bond ETFs like iShares U.S. High Yield Bond Index ETF (TSX:XHY) and Horizons Active High Yield Bond ETF (TSX:HYI) have become popular options for income investors as yields from other sources have collapsed. Both ETFs yield more than 5.5%.
But if we look at one simple ratio, it’s a bad time to buy U.S.-based junk debt.
That ratio is the spread between high-yield bonds and U.S. treasuries. When the spread is higher, it’s a more attractive time to buy junk bonds. When it’s lower, it has historically been a bad time to buy.
Recent history confirms it. In February 2016, the spread between high-yield debt and treasuries reached its highest level since 2011, peaking at approximately 9%. XHY shares have rallied close to 13% since then, as well as paying an attractive dividend. The total return was close to 20%.
Compare that to today. Since Donald Trump was elected, the spread between U.S. government debt and junk bonds has collapsed, settling in at approximately 4% today. The last time the spread was this low was mid-2014. Only 18 months later, XHY shares had fallen from $22 each to under $18, a decline of nearly 20%.
The junk bond premium was under 4% for an extended period between 2005 and 2008, and we all know what happened shortly after that. It was the greatest junk bond buying opportunity of our generation and a disaster for investors who bought during that time.
If an investor buys a junk bond ETF today, don’t expect much in capital appreciation. The asset class is just too expensive.
