Is It Time To Buy Junk?

Europe's debt woes, slowing global economic growth and the United States' own battle with ballooning debt have once again caused uncertainty to creep back into the markets. Over the last few weeks, investors have sought shelter in a variety of safe havens. Treasury bonds have recently posted their 11th straight week of gains, and money market fund balances have grown. As investor interest in high-risk assets such as commodities has waned, some opportunities have presented themselves. For those looking for yield, adding some exposure to junk bonds might be a good bet. TUTORIAL: Advanced Bond Concepts

Big Outflows
Six weeks worth of market declines in May and June have caused many investors to rethink risk in their portfolios. Junk bonds, which are essentially IOUs issued by corporations with less-than-stellar bond ratings, have experienced record outflows over the last few weeks as investors have made that move toward safety. Mutual funds that bet on the high-yield bonds saw outflows of nearly $3.4 billion during the final weeks of June. This was the highest level in nearly 20 years. The Barclays Capital U.S. High-Yield Bond Total Return Index dropped for 13 consecutive days, causing it to lose a total of 1.7%. This was the index's longest losing streak since a 14-day plunge during the height of the financial crisis in 2008.

Recent History Indicates a Sector Rally is Likely
However, investors may be jumping the gun about junk bonds and high-yield debt. Prolonged losing periods are quite rare in the sector, and after such routs these bonds tend to rally. According to research by Barclays Capital, in the eight times since 2001 that junk bonds have slumped for 10 or more consecutive days, investors earned an average of 6.3% during the next three months and 14.1% over the next six. In addition, many firms issuing high-yield debt have cut their debt levels from seven-times equity to just five times.

Current economic trends could help underscore the historical data. Falling oil prices and recovery in Japan could be enough to send the sector higher. In the current low-rate, slow recovery environment, high-yield bonds are actually good substitutes for riskier equities since their coupon payments provide equity like returns.

Finding Treasure in the Junk Pile
With interest rates still at low levels, junk bonds could be just what investors need to add a little yield to their portfolios. With the recent flight to quality, now could be a good time to add the asset class to a portfolio. To minimize the risk of default, investors should take a broad approach. Here are a few picks.

The two exchange-traded funds in the sector are the iShares iBoxx $ High Yield Corporate Bond (NYSE:HYG) and SPDR Barclays Capital High Yield Bond (NYSE:JNK), each with $8 billion and $6.8 billion in assets, respectively. HYG offers investors the largest portfolio of high-yield bonds with 465 holdings and yields 7.84%. The SPDR provides a higher yield at 8.25%, but portfolio size is smaller at 197 holdings.

Short-Term Bets
Investors still concerned about the potential for default can bet on short-term junk bonds via the PIMCO 0-5 Year High Yield (NYSE:HYS). PIMCO's sampling technique reduces indexes' 787 holdings to just 82, with a low duration of just 2.2 years and a yield around 6.9%. (To learn more about duration, see Advanced Bond Concepts: Duration.) On the opposite side of the spectrum, the new leveraged ProShares Ultra High Yield ETF (NYSE:UJB) offers junk bond investors extra "oomph".

Finally, for those investors looking for more active management from their high-yield investment, the Peritus High Yield ETF (NYSE:HYLD) is managed to produce the highest income stream. While the fund is new, it has outperformed the other high-yield funds over the past six months. Investors can also try the PowerShares Fundamental High Yield Corporate Bond Fund (NYSE:PHB), which selects bonds based on four factors including book value of assets, gross sales, gross dividends and cash flow.

The Bottom Line
With fear once again returning to the market, a variety of asset classes have seen their prices fall. For investors, the junk bond and high-yield sector offers a great opportunity for value. The preceding funds, along with the BlackRock High Income Shares (NYSE:HIS), make excellent choices to ride the rebound.

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