If the economy is heading into a black hole, why are investors bidding up the prices of some high-yield corporate bond exchange-traded funds? Prices paid for some ETFs are exceeding the value of the underlying securities, known as the net asset value. Such premiums were once the preserve of closed end funds. These days, anything is possible. Case in point: the massive premium being paid for the iShares iBoxx $ High Yield Corporate Bond Fund ( HYG), an ETF. HYG's NAV is about $66, but this hasn't stopped some investors from driving the price to $75. The yield is in the 11% to 12% range. But where there's yield, there's risk, especially during a recession. HYG invests in U.S. corporate bonds. Aside from a government bailout plan that may protect some corporate issues from default, the only other risk-mitigating factor I can see in this ETF is that it has 11% of its assets allocated to the electrical sector, 12% to health-care services and about 6% to oil and gas. Those industries might be more stable in a downturn and subject to a lower default rate. However, they account for only 27% of the portfolio, so risk looms large. The 52-week trading range for HYG has swung from a low of $62.50 recently to $102 about a year ago. As the economic crisis unfolded in August and September, the fund's price began to fall markedly, reflecting the severity of the situation. However, something else started to happen. The uptick in the price of the ETF's shares to $75 suggests a trading strategy is in play based on renewed confidence in high-yield securities and, perhaps, the economy in general. But there is no good economic news to suggest the country is on the mend. Perhaps some investors are pushing up the prices of high-yield ETF shares to lure others into some sort of short-term trading strategy.
A similar situation, but not as extreme, is evident with the iShares iBoxx $ Investment Grade Corporate Bond Fund ( LQD), which has an NAV of 96 and trades around $100 to yield 6%. This ETF is also invested in U.S. corporate bonds. It differs from HYG in that it has a 30% exposure to banks and 10% to financial services -- the worst-performing sectors. Unless you want to run outside and jump up and down, yelling "the recession is over," those industries are fraught with danger. So why the premium? There may be some legitimate reasons for these significant premiums to NAV. Investors may be willing to pay extra for diversified exposure to credits, rather than putting all their faith in individual issues. Or maybe they thought some covenants on funds' individual securities were violated, only to realize the government's assorted bailouts came to the rescue. Maybe somebody wants you to believe the worst is behind us, so he can put in place a strategy that leaves the unwary buyer of these ETFs holding the bag. Seems to be a lot of that going around lately.