Before you load up on junk, give it the sniff test, so you don't end up with a smelly surprise.
So far this year, mutual funds and exchange-traded funds investing in high-yield, or "junk," bonds have taken in more than $17 billion in new money. Roughly 15 cents of every dollar flowing into all stock and bond funds combined has gone into junk alone.
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Two high-yield ETFs, iShares iBoxx High Yield Corporate Bond (HYG) and SPDR Barclays Capital High Yield Bond (JNK), have taken in $5.7 billion between them, contributing to a 34% increase in assets since year-end.
Chasing income in an otherwise yield-parched market, investors have driven up junk-bond prices; the market has returned 5% year to date.
Investors need to bear in mind, however, that risk is rising, yields are falling and returns are bound to cool off.
The boom in junk-bond ETFs, say several analysts, is creating two distinct classes of bonds -- one of which might be riskier than the other.
ETFs seek to replicate the returns of an index by holding essentially all the securities included in that market benchmark. The bonds in the indexes that high-yield ETFs use, say analysts, have been behaving differently from comparable bonds outside the benchmarks.
When investors buy the ETFs, that causes more demand for the bonds in their indexes, pushing up prices. But when investors dump the ETFs, that puts selling pressure on the same bonds, knocking down their prices relative to similar bonds outside the indexes.
"ETFs have their costs and their benefits," says Oleg Melentyev, head of high-yield corporate strategy at Bank of America Merrill Lynch. "And this is one of their costs."
As money flowed into high-yield ETFs last year, the bonds held by the ETFs beat similar bonds that the ETFs didn't own by a cumulative 0.99 percentage point for the full year, according to Bradley Rogoff, a credit strategist at Barclays Capital. But last summer, when nearly $1 billion flowed out of the ETFs, their bonds performed about three percentage points worse than comparable bonds.
The two top sponsors of junk ETFs don't think they have distorted prices or raised volatility. Matt Tucker, head of fixed-income investment strategy at iShares, argues that with roughly $25 billion in assets in a $1 trillion market, the biggest ETFs "aren't anywhere near the point where we're going to have a lot of impact on the underlying securities."
Says James Ross, managing director at the SPDR funds: "If investors decided to flee, there obviously would be some impact on performance. But what's the velocity of that? You just don't know."
There is another wrinkle. A bond ETF is a basket of many bonds that can be traded like a stock. So, when junk bonds are popular, the ETFs may be in even greater demand, since they are easier to trade than a multitude of bonds. Conversely, when investors flee the high-yield market, the ETFs may sell off a bit more sharply than the underlying bonds.
Since junk bonds are less liquid than ETFs, "there's almost always going to be at least a small premium or discount on the ETF shares," says Chris Taggert, an analyst at research firm Credit Sights. That also is true for ETFs that hold other illiquid assets like municipal bonds and emerging markets.
Over the past few weeks, the premium on the shares of the two biggest junk ETFs has averaged about half a percentage point -- meaning investors have been paying $100.50 for every $100 worth of assets.
In January, the junk ETF shares traded around a 0.6% premium to the value of their assets -- even as the bonds they held were 0.6% more expensive than comparable high-yield debt, estimates Mr. Melentyev of Merrill Lynch. That was a premium on top of a premium.
Toss in management fees of 0.4% to 0.5%, and the buyers of these funds were effectively paying nearly 2% just to get in the door.
If a junk fund's shares are trading at a premium to their underlying value, say experts, chances are the bonds in the fund also are overpriced.
You should try to buy the shares when they are at a discount. Then, you may well be getting the underlying bonds when they, too, are on sale.
You can check discounts and premiums on the funds' websites, or on Yahoo Finance by entering the letters "-IV" after a fund's ticker symbol.
Mr. Melentyev and Martin Fridson, global credit strategist at BNP Paribas Investment Partners, say a reasonable expectation for total return on junk over the next 12 months is 7% to 8%. That assumes the U.S. economy doesn't sink back into recession, oil prices don't spike upward and there is no geopolitical bolt from the blue.
That 7% to 8% base case also doesn't apply for impulsive buyers who could easily earn 2% less if they rush into buying a double premium.
If you are going to invest for higher yield, the first step is to lower your expectations.
—intelligentinvestor@wsj.com; twitter.com/jasonzweigwsj
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