With an economy that is potentially on the brink of falling apart, junk bond ETF investing probably isn’t on the forefront of most investors’ minds. Yet, products in this slice of the market have held up surprisingly well in the turmoil thanks to ultra-low default rates, yields that thoroughly outperform ‘safer’ government bond payouts, and capital gains that beat out equities. In fact, according to recent reports, high-yield corporate bonds have outperformed the S&P 500 by 5,300 basis points when looking from October 2007 to the end of November 2011. “Keep in mind that from a total return standpoint, this sector has absolutely crushed the equity market in the past four years,” said David Rosenberg, chief economist and strategist at Gluskin Sheff + Associates. in his Breakfast with Dave report.
Thanks to these trends, the high yield space has begun to see more interest despite the floundering economic environment. This could be especially true if default levels remain at rock bottom rates; the trailing 12-month default rate was just 1.94% in September and is expected to rise to only 3.1% in the next nine months. While this is obviously a large increase, investors should note that this is still below the long-term average default rate of 4.6% according to Standard & Poors, suggesting that we are still in an environment that has few credit events (see Top Three High Yield Real Estate ETFs).
Another favorable aspect of the junk bond world is the ultra-high yields on these securities. These payouts, which can often be above 6%, are far higher than comparable Treasury bonds as well as many international government counterparts. Since default rates have been so low and the duration of these securities tends to be lower than other corners of the fixed income market, this hefty yield premium could be worth chasing for most investors in this environment (read Three Outperforming Active ETFs).
Given these favorable metrics in all three of the key aspects of junk bond investing—yield, capital appreciation, and default rates—it may now be the time to consider a bigger allocation to the sector. This could be especially true for investors seeking to boost yields or just diversify the bond component of a portfolio. Below, we highlight three excellent choices that investors have when considering an allocation to this potentially lucrative space:
iShares iBoxx $ High Yield Corporate Bond Fund (HYG)
This fund seeks investment results that correspond generally to the price and yield performance, before fees and expenses, of the iBoxx $ Liquid High Yield Index, a corporate bond market index compiled by the International Index Company Limited. By following this benchmark, the product has close to 470 holdings with heavy exposure to the short and intermediate portions of the curve. In fact, the weighted average maturity of the product is just 5.6 years (read ETFs vs. Mutual Funds).
Bonds of consumer services companies comprise the biggest part of the portfolio and are closely trailed by financials and telecoms. The fund charges investors 50 basis points a year in fees but pays out a robust 30 Day SEC Yield of 7.8%. In terms of capital appreciation, HYG has had an average year as the product has lost about 2.9% since the start of January.
SPDR Barclays Capital High Yield Bond Fund (JNK)
JNK is the most popular ETF in the high yield category from a trading volume perspective, as 3.8 million shares change hands every day. The fund tracks the Barclays Capital High Yield Very Liquid Index which includes publicly issued U.S. dollar denominated, non-investment grade, fixed-rate, taxable corporate bonds. These securities must also have a remaining maturity of at least one year, regardless of optionality, are rated high-yield (Ba1/BB+/BB+ or below) using the middle rating of Moody’s, S&P, and Fitch, respectively (before July 1, 2005, the lower of Moody’s and S&P was used), and have $600 million or more of outstanding face value.
JNK holds 222 securities in total with a heavy focus on the middle and short parts of the curve. In fact, the modified adjusted duration of the product is just 4.55 years while close to 75% of the bonds in the fund mature from five to ten years from now (options help to push the duration below the five year level). In terms of fees, JNK is among the cheapest in the space charging investors just 40 basis points a year. Its performance metrics are also pretty good, as the fund has a 30 Day SEC Yield of 8.1% but this junk bond ETF has lost 3.9% in year-to-date terms (see Three Low Beta Sector ETFs).
PowerShares Fundamental High Yield Corporate Bond Fund (PHB)
For investors looking for a more fundamental approach, PHB could be the junk bond ETF of choice. The product tracks the RAFI High Yield Bond Index which consists of U.S. dollar-denominated bonds registered for sale in the U.S. that have at least one year until maturity. However, unlike other products in the space, this ETF weights securities by a combination of fundamental factors. Chief among these metrics are a focus on companies that have publicly available accounting data as well as giving higher weights based on issuer fundamentals as opposed to the size of the bond offering. This can potentially give investors a completely different portfolio of securities that can create a new way to play the bond market.
PHB holds 206 securities in total, charging investors 50 basis points a year in fees for its services. The fund has a lower effective duration than other products on the list—thanks in part to the more ‘active methodology’—coming in at just 4.25 years. In terms of sector exposure, consumer companies take some of the top spots and they are closely trailed by companies in the energy and financial sectors. Due to its focus on higher quality junk securities, PHB can underperform on a yield basis, paying out 5.8% in 30 Day SEC terms. However, for capital gains, the product is a star performer as it has managed to stay flat on the year despite the broad turmoil in the market and the modest losses in many other products in the category (read Inside The SuperDividend ETF).
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