A Muni Fund to Buy Before Junk ETFs

We’re in the stage of the yield chase where warnings about future pain are a dime a dozen while signs of tangible credit stress are few.

Junk bonds are historically expensive. This also is true of most other flavors of debt as well as equity. The rising tide in financial asset prices has helped the iShares iBoxx High Yield Corporate Bond ETF (HYG) return 24% (including distributions) from its lows in early 2016.

Those lows took place amid a panic about shale driller bonds that proved premature. Less than two years later, the junk bond market is trading downright cocky.

Bond traders got ambushed by last month’s bankruptcy of Toys R Us but shrugged it off. The default rate on junk bonds as a whole remains historically low. The economic trend has been favorable and cheap refinancing options plentiful.

That’s helped even a high-risk issuer like Valeant Pharmaceuticals (NSDQ: VRX). The shrinking pharma roll-up is saddled with a mountain of deb and eroding sales, yet sold $1 billion in secured eight-year notes this week at an effective annual yield of 5.6%. The proceeds will refinance costlier debt maturing sooner.

The debt party won’t go on indefinitely, but while it does there’s a good chance HYG and the SPDR Bloomberg Barclays High Yield Bond ETF (JNK) will continue to underperform the junk bond sector. The ETFs face steep transaction costs as the most active buyers and sellers in a relatively illiquid market. They also tend to overweight issuers with the most debt at the expense of smaller and potentially more rewarding credits.

And when the debt markets turn down the likely fund flows out of these ETFs will turn them into disproportionate losers and catalysts of further declines. That’s a lot of risk to take on for annualized yields of 5% (HYG) and 5.7% (JNK).

Municipal debt yields even less in the aggregate, of course, but is a safer bet at this stage of the economic and credit cycles. The Nuveen AMT-Free Muni Credit closed-end fund (NVG) has a trailing distribution rate of 5.6%, though it gets there by leveraging its portfolio.

Still, consider the advantages NVG’s worst credit has over a corporate borrower like Valeant. If Valeant can’t reverse its revenue decline (and there is no evidence that any such turnaround is likely) it will eventually find itself unable to meet its obligations no matter how many times it refinances in the interim.

Meanwhile, the Chicago Public School system keeps piling up long-term debt to meet operating budget deficits. It’s as risky a municipal credit as there is outside of Puerto Rico. But if the district should ever fail to come up with what it owes, the shortfall will be automatically made up by property tax hikes. Valeant’s creditors don’t have that backstop.