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.

Related Articles
  1. Bonds & Fixed Income

    Junk Bonds: Everything You Need To Know

    Don't be fooled by the name - junk bonds may be for you if you know how to analyze them.
  2. Investing

    Five Things to Consider Now for Your 401(k)

    If you can’t stand still, when it comes to checking your 401 (k) balance, focus on these 5 steps to help channel your worries in a more productive manner.
  3. Investing Basics

    Explaining Financial Assets

    A financial asset is intangible property that represents a claim on ownership of an entity or contractual rights to future payments.
  4. Mutual Funds & ETFs

    ETF Analysis: ProShares UltraPro Nasdaq Biotech

    Obtain information about an ETF offerings that provides leveraged exposure to the biotechnology industry, the ProShares UltraPro Nasdaq Biotech Fund.
  5. Mutual Funds & ETFs

    ETF Analysis: iShares MSCI Europe Financials

    Learn about the iShares MSCI Europe Financials fund, which invests in numerous European financial industries, such as banks, insurance and real estate.
  6. Mutual Funds & ETFs

    ETF Analysis: SPDR S&P Insurance

    Learn about the SPDR S&P Insurance exchange-traded fund, which follows the S&P Insurance Select Industry Index by investing in equities of U.S. insurers.
  7. Mutual Funds & ETFs

    ETF Analysis: SPDR S&P Emerging Markets Small Cap

    Learn about the SPDR S&P Emerging Markets Small Cap exchange-traded fund, which invests in small-cap firms traded at the emerging equity markets.
  8. Mutual Funds & ETFs

    ETF Analysis: ETFS Physical Platinum

    Learn about the physical platinum ETF. Platinum embarked on a bull market from 2001 to 2011, climbing to record prices along with other precious metals.
  9. Mutual Funds & ETFs

    ETF Analysis: iShares MSCI Turkey

    Learn about the iShares MSCI Turkey exchange-traded fund, which invests in a wide variety of companies' equities traded on Turkish exchanges.
  10. Mutual Funds & ETFs

    ETF Analysis: PowerShares S&P 500 Downside Hedged

    Find out about the PowerShares S&P 500 Downside Hedged ETF, and learn detailed information about characteristics, suitability and recommendations of it.
RELATED TERMS
  1. Yield To Maturity (YTM)

    The total return anticipated on a bond if the bond is held until ...
  2. Exchange-Traded Fund (ETF)

    A security that tracks an index, a commodity or a basket of assets ...
  3. Security

    A financial instrument that represents an ownership position ...
  4. Discount Bond

    A bond that is issued for less than its par (or face) value, ...
  5. Credit Rating

    An assessment of the credit worthiness of a borrower in general ...
  6. Long-Term Debt

    Long-term debt consists of loans and financial obligations lasting ...
RELATED FAQS
  1. What are the maximum Social Security disability benefits?

    The maximum Social Security disability benefit amount for a single eligible person in 2015 is $1,165 per month, but you can ... Read Full Answer >>
  2. What is the relationship between the current yield and risk?

    The general relationship between current yield and risk is that they increase in correlation to one another. A higher current ... Read Full Answer >>
  3. What does a high turnover ratio signify for an investment fund?

    If an investment fund has a high turnover ratio, it indicates it replaces most or all of its holdings over a one-year period. ... Read Full Answer >>
  4. Does index trading increase market vulnerability?

    The rise of index trading may increase the overall vulnerability of the stock market due to increased correlations between ... Read Full Answer >>
  5. What is the difference between passive and active asset management?

    Asset management utilizes two main investment strategies that can be used to generate returns: active asset management and ... Read Full Answer >>
  6. How does the bond market react to changes in the Federal Funds Rate?

    The bond market is highly sensitive to changes in the federal funds rate. When the Federal Reserve increases the federal ... Read Full Answer >>

You May Also Like

COMPANIES IN THIS ARTICLE
Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!