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Forget BOND, Focus on These Junk Bond ETFs Instead

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In the past few months, investors have shown an increased appetite for the equity world rather than fixed income. This is particularly true given the improving U.S. economy, deepening Euro zone crisis and an ultra-low interest rate environment (read: 3 ETFs at the Heart of the Recent Rally).

Further, the concern related to the winding down of the monetary easing policies by the Fed is growing globally. A pullback in such stimulus should raise the interest rates from their rock-bottom levels, thereby hurting the bonds prices. Bond yields and prices have an inverse relationship with each other.

In such a backdrop, the Pimco Total Return ETF (BOND - Free Report) , by far the largest actively managed bond ETF, broke its asset-gathering streak since its debut in March 2012 with its first monthly outflow in May. Furthermore, BOND has seen a huge outflow of $119 million in just the first five days of June. With this, the total AUM of the fund has dropped to $4.9 billion.

A big reason for this asset slump is because the ETF has significant exposure to mortgage-backed securities (38%) and Treasuries (24%). Last month, mortgage-backed securities were stressed by the speculation that Fed might slow or stop its asset-purchase program anytime soon (read: Mortgage REIT ETFs: Is The Plunge Over?). Treasuries also witnessed a huge sell-off last month, suggesting that the long-standing bond rally might come to a halt.

Additionally, about three-fifths of BOND’s portfolio focuses on medium-term maturity levels ranging from 3–5 years and 5–10 years collectively. Hence, the fund would be in danger if the rates suddenly increase. The ETF lost 2.5% in May alone while the year-to-date return is slightly negative at 0.18%.

High Yield Bond ETFs in Focus

In the current environment, yield-hungry investors could view high-yield bonds as good sources to maximize current income in the form of interest, especially compared to other avenues which have low yields attached to them  (read: Comprehensive Guide to U.S. Junk Bond ETF Investing).

This is particularly true now as traditional bonds like U.S. Treasury securities yields are near their low levels. The high-yield securities have lower correlation to the broad equity markets. In addition, these bonds provide a cushion against rising interest rates as these are generally less sensitive to interest rate fluctuations.

Further, given low default rates and low duration compared to the other corners of the fixed income market, this hefty yield premium could be worth chasing. Hence, many investors continue to embrace high-yield bond ETFs for their portfolio despite fears of a bond bubble and soaring equity prices.

While there are a number of options in this segment, we have taken a closer look at the two high-yield corporate bond ETFs with shorter durations that could provide a nice balance in the current low rate environment even if the interest rate rises in the near future.

These funds could provide investors with income potential and relatively stable returns while maintaining low correlated assets, and thus be high quality picks for investors (read: Are Short Term Bond ETFs the New Safe Haven?).

0-5 Year High Yield Corporate Bond Index Fund (HYS - Free Report)

This first ETF provides exposure to the short-term high-yield corporates and was initiated by PIMCO in June 2011. The fund seeks to match the performance of the BofA Merrill Lynch 0-5 Year US High Yield Constrained Index, holding 324 securities in the basket.

About 56% of the product’s holdings mature in less than 3 years, giving HYS an effective duration of only two years and effective maturity of 2.8 years. In terms of credit quality, the fund focuses on non-investment grade bonds, allocating 76% of the portfolio to bonds rated ‘BB’ or lower.

The product has so far attracted assets worth $2.2 billion and trades in good volume of more than 250,000 shares on a daily basis. The ETF has returned nearly 1.5% year-to-date, in line with many other products in the space (read: Emerging Market Bond ETFs: Time to Buy?).

However, its 30-day SEC yield of 3.12% appeals to investors seeking current income, while it represents a reasonably priced choice in the space as it costs 55 basis points a year.

SPDR Barclays Capital Short Term High Yield Bond (SJNK - Free Report)

Investors looking for short-term exposure to the high-yield corporate space may also look at the State Street’s entrant into the space. Launched in March 2012, this ETF seeks to match the price and performance of the Barclays Capital US High Yield 350mn Cash Pay 0-5 Yr 2% Capped Index, before fees and expenses.

With holdings of 374 securities, about 70% of the fund’s assets mature in less than 5 years, giving lower average duration of 2.41 years and effective maturity of 3.57 years. Additionally, the fund focuses mainly on BB and lower rated bonds (see more in the Zacks ETF Center).

The fund charges 40 bps in fees from investors and has over $1.3 billion in AUM. It is extremely liquid trading in quantities of over 550,000 shares per day. SJNK provides an attractive 30-Day SEC yield of 4.12% and has added roughly 1.50% in the year-to-date timeframe.

Bottom Line

Many investors continue to embrace high-yield bond ETFs for their portfolio despite fears of a bond bubble and soaring equity prices thanks to outsized yields and the relatively low default levels.

The short-term high-yield bond ETFs have gained tremendous popularity as evidenced by their impressive asset inflow last month. In fact, HYS accumulated $238.51 million in its asset base while SJNK has seen a bit less asset inflow of $135.95 million in one month alone. Both ETFs currently have a Zacks ETF Rank of # 3 or Hold rating.

Still, the continued anxiety over lofty equity levels as well as skepticism surrounding the unrealistic risk-return tradeoff of long-term bonds and the sheer unattractiveness of gold have made these bond ETFs exciting plays. So if investors are still looking to invest in the bond market, consider either of the aforementioned ETFs as solid plays in today’s type of uncertain environment.

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