The Potential for High-Yield Bond ETFs to Outperform in the Fixed Income Market in 2024

Junk-bond ETFs may surprise investors with their outperformance this year, according to State Street Global Advisors’ chief investment strategist, Michael Arone. Arone believes that high-yield bonds, also known as “junk” bonds due to their below-investment-grade ratings, have the potential to outperform in 2024 under a “soft-landing” scenario for the U.S. economy.

Despite concerns about a potential recession, high-yield bonds have been resilient, and their performance this year has been positive, with the SPDR Bloomberg High Yield Bond ETF (JNK) and iShares iBoxx $ High Yield Corporate Bond ETF (HYG) both experiencing modest gains. In contrast, ETFs that track the U.S. investment-grade bond market, such as the iShares Core U.S. Aggregate Bond ETF (AGG) and Vanguard Total Bond Market ETF (BND), are still down for the year.

Arone’s optimism for high-yield bonds stems from the belief that these bonds can fare well in an economy that continues to grow steadily. While some investors are concerned about the Federal Reserve’s monetary tightening measures leading to an economic slowdown, Arone argues that high-yield bonds can thrive in such an environment.

However, high-yield bond ETFs have not been popular recently, with $387 million of net outflows in the week through February 14th. On the other hand, ETFs targeting fixed income as a whole attracted $2.8 billion of net inflows over the same period.

One potential risk for high-yield bonds is the tight spreads, which may widen in a slowing economy and negatively impact returns. Despite this concern, Arone believes that many investors are more willing to take rate risk rather than credit risk in junk bonds. They expect falling interest rates to result in price gains in the bond market.

As investors continue to monitor the Fed for clues about potential rate cuts, Arone suggests an investment approach that includes short-term debt and bonds with intermediate durations. He specifically mentions the SPDR Portfolio Intermediate Term Corporate Bond ETF (SPIB) as a favorable option. Junk bonds, with a yield of around 8%, also have less duration risk compared to long-term bonds.

The performance of high-yield bond ETFs this year has been relatively stable, with a total return of 0.2% for both the SPDR Bloomberg High Yield Bond ETF and iShares iBoxx $ High Yield Corporate Bond ETF. In contrast, the Vanguard Total Bond Market ETF has experienced losses of 1.5% on a total-return basis, while the Vanguard Long-Term Treasury ETF has seen a steeper total loss of 4.8%.

In conclusion, while high-yield bond ETFs may not be the most popular choice among investors at the moment, they have the potential to outperform in 2024 under certain economic conditions. With their resilience and positive performance this year, these bonds offer an alternative investment option for those willing to take on more risk for potentially higher returns.