With interest rates still in the basement and Treasury bonds yielding next to nothing, investors have been forced to look outside the box in order to find income. For those wanting to stay within bonds, that means loading up on junk bonds and funds like the SPDR Barclays High Yield Bond ETF (JNK).
High-yield bonds have been on an absolute tear since the Great Recession and continue to rack up impressive gains. So much so that the average junk bond is now only yielding 5%. That has plenty of investors wondering whether the risk is worth the return.
The answer may come down to how you think about high-yield bonds in your portfolio. The truth is that junk could still be where it’s at for quite a while. (For related reading, see: Is The Party Over For Junk Bonds?)
Risk and Potential Reward
According to investment researcher and ratings service Morningstar Inc. (MORN), investors have already moved a cool $5.4 billion into high-yield bond funds in the first four months of 2014. That’s on top of the $3.4 billion they invested in the sector during all of 2013. All of this yield-searching has allowed the sector to return nearly 8% last year and around 5.16% year-to-date.
It’s also caused yields on the bonds issued to companies with lower creditworthiness to plummet to just 5% – well below historical norms. That has many investors worrying that the sector is now reaching overvalued territory.
While there is some validity to the argument, there still are plenty of bullish tailwinds propelling the high-yield bond sector, one of which is stable or falling default rates. (For related reading, see: Junk Bonds No Longer Junk)
Economic growth is helping companies meet their financial obligations, meaning that default rates for junk bonds are still below their historic averages. A recent report from Moody’s Investor's Service shows that junk bond default rates in the U.S. held steady at just 2.1% in May. The figure for the rest of the globe fell to 2.3% in May, down from 2.5% in April. That average default rate is still well below the 4.5% reached in the 1990s.
What About Rising Rates?
The specter of rising interest rates may not be all that detrimental to junk bonds. Due to their nature, junk has actually done quite well in the face of raising rates. According to TIAA-CREF, during prior periods of relatively moderate and steady interest rate increases, junk actually produced positive returns. Looking at the period between 1998 and 2013, of the 14 times that Treasury yields spiked, high-yield bonds produced a return of 4.99%. Regular corporate bonds returned -0.48% and Treasuries -5.53%. (For related reading, see: Junk Bonds: Everything You Need To Know)
Betting on Junk
So there’s still room for good news for junk bond investors, albeit with a grain of salt. The lesson here is to be cautiously optimistic. That means investors may want to trade out broad junk bond index funds, such as the popular iShares iBoxx $ High Yield Corporate Bond ETF (HYG) or the aforementioned JNK, for some active management. Active managers can shift through the sector and pick out the best bonds for the new environment. A prime starting point could be the AdvisorShares Peritus High Yield ETF (HYLD).
HYLD’s managers take a “value-based, active credit” approach to the sector. The fund tracks 74 different companies, with Arch Coal Inc. (ACI) and Air Canada bonds as some of its top holdings. That focus on credit and deeply valued bonds helps HYLD produce a monster 7.71% distribution yield. The only drawback is the ETF's high 1.25% expense ratio. Another option could be the PowerShares Fundamental High Yield Corp Bond (PHB), which uses screens to create an index of junk bonds on the better end of the spectrum. (For more on this topic, see: 4 High Yielding Junk Bond ETFs)
For options at the upper end of the risk spectrum there's the iShares Baa - Ba Rated Corporate Bond ETF (QLTB) and the Market Vectors Fallen Angel High Yield Bond ETF (ANGL), which buys bonds of companies that were once considered investment grade that have now slipped down to junk status. QLTB yields 4%, while ANGL yield's a hefty 5.5%.
Finally, investors have flooded the senior and floating-rate bank loan market looking for yield. Similar to junk bonds, these loans are often made to firms with less-than-stellar credit. Like the previously mentioned HYLD, the SPDR Blackstone/GSO Senior Loan ETF (SRLN) applies active management to this sector of the high-yield marketplace. SRLN's managers can then weight the risks/rewards accordingly.
The Bottom Line
Despite recent gains, junk bonds still could be a good bet for investors based on a variety of factors working in their favor, such as stable or falling default rates and improving economic conditions. The key could be focusing on quality within the space. Accordingly, a dose of active management could be just what the doctor ordered.