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Junk Bond ETF Investing: Is It Too Late?

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High yielding investment avenues have been the focus of investors for quite some time now thanks to the ultra low interest rate policy of the Federal Reserve. This is especially true in the bond space, as correlation between this asset class and stocks has remained low, while volatility levels haven’t been bad either.

Traditionally these High Yield (i.e. Junk) bond ETFs are comprised of those bonds which are rated below investment grade by the major credit rating agencies. These bonds have higher rates of interest attached in order to compensate for the credit risk premium associated with them.

Apart from individual factors such as the credit rating of these individual bonds, interest rates attached to the high yield bonds are functions of other macroeconomic variables such as Treasury Rates and Inflation Rates. Therefore a falling interest rate scenario, such as the present one, offers a lucrative opportunity for both players, i.e. issuers as well as investors to capitalize on the opportunities.

In this type of market, yield hungry investors 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. And given the extremely low default rates, these bonds are compelling values that haven't been all that risky (read Comprehensive Guide to U.S. Junk Bond ETF Investing).

Also, it is also prudent to note that the U.S economy will not be in recovery mode forever, thus after the economy goes back on track in alignment to the standards of the policymakers, it is inevitable that interest rates would increase in future (read ETFs in a QE3 World).

This could severely impact high yield investors and slowly but surely their appetite for high yield bonds will start to subside. This would result in decreased demand for these instruments and finally lead to the prices taking a hit, resulting in massive dent in the portfolios of investors invested in them.

Therefore we see that these bonds will eventually face the heat of selling pressure and a rising interest rates. But when? And for how long? In the recent past we have seen and heard many believing that this year the bond markets are going to witness massive sell offs and bond investors would lose a fortune. However, that has clearly failed to happen.

In fact, investors in bonds or bond ETFs (Treasuries, Corporate Bonds as well as High Yield ones) have fetched decent and steady returns for themselves over the past one year which is probably going to be the case going in to 2013 as well. This is especially true given the broad dollar strength, and lingering questions over the health of the American economy, a situation that could keep rates relatively low across the board.

However, there is no denying the fact that interest rates have to be equated to their pre-recessionary levels some time in future and bonds will eventually have to lose value, but at least in the near term that s not likely to take shape. So until we see a big move higher in rates, high yield bond ETFs will continue to fetch decent total returns for investors and clearly the end for bond investors is not here just yet (read Play Four Megatrends with These ETFs).

Below, we highlight three of the biggest and most popular junk bond ETFs currently on the market. Any of these could be great ways to play the sluggish interest rate environment with impressive yields in the short-term:

iShares iBoxx $ High Yield Corporate Bond ETF (HYG)

HYG was launched in April of 2007 and has an asset base of $16.27 billion. The ETF charges an expense ratio of 50 basis points and holds a well diversified portfolio of 716 securities. On average, more than 3 million shares of HYG trade each day.

The ETF pays out a yield of 6.76% and has returned 4.69% in terms of capital appreciation to the investors. The ETF targets the intermediate part of the yield curve and has a weighted average maturity of 4.41 years and moderate interest rate risk as indicated by an effective duration of 4 years.

HYG tracks the iBoxx $ Liquid High Yield Index which tracks the performance of the high yielding space in the U.S corporate debt market. In terms of yearly performance, the ETF has generated excellent total returns of around 12.2%.

SPDR Barclays High Yield Bond ETF (JNK)

The ETF tracks the Barclays Capital High Yield Very Liquid Index which measures the performance of high yield bonds issues by corporates within the U.S. These bonds are U.S. dollar denominated so currency risk issues will not be a problem for American investors.

The ETF had its inception at the same time as HYG and has managed to amass an asset base of around $12.50 billion. JNK has an average daily volume of more than 4.5 million shares and charges investors an expense ratio of 40 basis points (see more in the Zacks ETF Center).

JNK pays out a yield of 6.83% and fetched an impressive 6.5% return as capital appreciation. However, on a one year look, JNK has generated 12.5% in terms of total returns. The ETF holds 313 securities in its portfolio.

PowerShares Fundamental High Yield Corporate Bond ETF (PHB)

Yet another ETF that tracks the performance of the high yielding U.S. corporate bonds as measured by the RAFI High Yield Bond Index, PHB was also launched in the same year as HYG and JNK.

However, it lags behind the other two in terms of popularity as indicated by an asset base of just $844.17 million. PHB also charges investors 50 basis points in fees and expenses and pays out a yield of 5.12% (read 3 Developed Market ETFs Crushing American Stocks).

The ETF tracks the intermediate part of the yield curve and has moderate interest rate risk as indicated by an average residual maturity of 6.21 years and effective duration of 3.90 years. On average, nearly 674,000 shares of the ETF are traded each day.

The ETF pays out a yield of 5.12% and has returned 4.43% in terms of capital appreciation. However on a one year look PHB has returned around 10% in terms of total returns.

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