Amid historically low interest rates, high yield bonds, called junk bonds because of their low credit ratings and high default risk, are attracting heavy inflows of funds from yield-hungry investors. “With interest rates falling globally, investors are searching for streams of income and finding them through high-yield products, given there are limited alternatives out there,” Todd Rosenbluth, head of ETF and mutual fund research at CFRA Research, told Bloomberg.

Indeed, junk bond funds listed in Europe have pulled in over 5 billion euros (about $5.6 billion) so far in 2019, more than in any full year since at least 2010, per analysis by Bloomberg. Leading the way has been the largest ETF in this space, the iShares Euro High Yield Corporate Bond ETF (IHYG) from BlackRock, whose assets are 8.5 billion euros (over $9.5 billion) after pulling in a record 640 million euros (over $700 million) during the week ending July 5, which beat the prior record set just 2 weeks earlier.

Key Takeaways

  • ETFs devoted to European high yield debt have record inflows.
  • Investors eager for higher returns are plunging in, despite the risk.
  • Worries are mounting that this may be a speculative bubble.

Significance For Investors

ETFs have been the preferred vehicle for investing in European high yield debt, accounting for more than 60% of the net new funds invested in these bonds so far in 2019, according to analysis by JPMorgan Chase cited by Bloomberg. The average return on these bonds was 8.1% in the first half of 2019, their best performance since 2012, per the same sources.

“There’s an art to knowing when to leave the party,” warns Pilar Gomez-Bravo, a former senior credit analyst at Lehman Brothers who is now a portfolio manager at MFS and its director of fixed income for Europe, in an extensive interview with Bloomberg. “In fact it’s over--people are desperate and they’re hunting down the after-party. We probably only have a few hours left,” she added.

Gomez-Bravo worries that a speculative bubble is building in European junk bonds, and she's heading for the exits. She oversees $4.5 billion in fixed income assets, and has cut the high yield exposure in one of her funds from 30% in 2016 to 10% today. “There’s more risk than reward right now,” she says. “There are real end-of-cycle fears about what performs,” she added.

In particular, Gomez-Bravo saw a red flag when average U.S. high yield bond spreads fell below 375 basis points (bps), a level that historically points to negative excess returns in the year ahead. The same signal turned noted credit bull Bob Michele of JPMorgan Asset Management into a bear in June, Bloomberg observes.

“It’s just a mindless bond market rally--once it gets going, it gets going,” warned Chris Rupkeym, the chief financial economist at MUFG Union Bank, per Bloomberg. “I don’t know who’s trading these markets. It doesn’t feel like its trading completely logically here," he added.

Looking Ahead

Strategists at Citigroup warn that slower economic growth will be most damaging to companies with the highest leverage, per Bloomberg. If the yield on the 10-Year U.S. Treasury Note drops below 2%, they believe that this will signal trouble ahead for junk bonds. The yield on the T-Note dipped to 2.057% in early trading on July 18, and has been as low as 1.940% so far in July, per CNBC.