As the Fed has kept interest rates at persistently low levels, investors have shown a penchant for anything that kicks off a high dividend. Master limited partnerships (MLPs), real estate and dividend paying stock funds- like the Guggenheim S&P Global Dividend Opportunity ETF (NYSE: LVL) -have become portfolio necessities as investors try to navigate these uncharted waters.
That is, until the Federal Reserve began their tapering stance.
Since then, a variety of high yield sectors have sold off as the Fed begins winding down its bond purchases. Surprisingly resilient to the taper has been high yield or junk bonds. The sector surged in 2013 and more gains could be ahead for investors.
Despite returning 8% last year, the high yield bond sector may be a great place for investors to place their money in 2014. A variety of analysts predict the sector could see similar total returns for the full year. The reason: better global economic data. Companies that issue junk bonds have spotty credit scores and their returns are highly correlated with economic health rather than the level of interest rates.
According to analysts at Invesco, the high yield sector has only had negative returns four times since 1980. Each of those periods of loses were associated with a recession. As economic growth in the U.S. continues to move ahead, forecasts for GDP increases in 2014 are within the 2 to 2.5% range. Invesco’s data shows that this amount of GDP growth is usually highly supportive of junk bond returns. Globally, analysts are predicting similar GDP gains- 2.84 % this year and 3.07% in 2015.
Aside from strong economic growth propelling junk bonds, there are a few other bullish catalysts as well.
Perhaps the biggest is that defaults rates are still below historic averages. A recent report from Moody’s shows that junk bonds' default rate for the fourth quarter of 2013 fell to just 2.2%. That’s down from 2.7% in the previous quarter and 3.4% a year earlier. The junk bond default rate reached a high of 13.4% in the third quarter of 2009. That rate should remain low as most of the new issuance has helped dramatically lower near-term maturities. Additionally, earnings for junk bond issuers have been rising faster than debt levels in the fourth quarter.
Finally, the supply of new junk bonds is slowing. Last year set a record in nearly $400 billion worth of new high-yield bonds. Analysts now predict that 2014 will see a 15% decline from that amount. That lends itself to higher prices.
Adding Some Exposure
Given the generally supportive market for junk bonds, investors may want to add some high-yield exposure. The biggest exchange traded fund (ETF) in the sector is the $13 billion iShares iBoxx $ High Yield Corporate Bond (NYSE: HYG). The ETF tracks 900 different junk bonds from issuers like Sprint (NYSE: S) and Springleaf Financial (NASDAQ: LEAF). Average credit quality for the fund is in the upper tier of the junk bond ratings scale. This produces a hefty 5.68% yield. For a slightly more concentrated and higher yield fund, the SPDR Barclays High Yield Bond (NYSE: JNK) could also be used.
Another option could be bank loan funds. These bonds usually have coupons that rise when interest rates do and reset every 30 to 90 days. Perhaps more importantly, the S&P/LSTA U.S. Leveraged Loan 100 Index- the main benchmark of these bonds- increased for the first time since October of 2012 when the floating rate debt level advanced despite a monthly drop in the S&P 500 index.
That means investors may be shifting from stocks to loans for yield and safety. The PowerShares Senior Loan Portfolio (NAASDAQ: BKLN) tracks the benchmark index and currently yields 4.26%. That yield should increase as interest rates rise. Another option is the actively managed SPDR Blackstone/GSO Senior Loan ETF (NASDAQ: SRLN). This ETF uses screens to find the “best” bank loans and yields 2.14%.
Finally, investors may want to broaden their search and head overseas for high yield bets. International junk bonds have fallen by the wayside as investors have shunned risk. Yet, many of these firms are just a stable as U.S. junk bond issuers. The Market Vectors International High Yield Bond ETF (NYSE: IHY) can be used to bet on developed market issuers, while the iShares Emerging Markets High Yield Bond (NASDAQ: EMHY) can be used to add a swath of emerging market junk bonds. The ETFs yield 6.39% and 6.16%, respectively.
The Bottom Line
For those investors looking for a good balance of risk and reward, high yield bonds could be a great play this year. There’s plenty of bullish catalysts that should propel junk bonds ahead.
Disclosure: The author has investments in the iShares Emerging Markets High Yield Bond.