High Times In High-Yield Ahead

By Aaron Levitt | May 30, 2012 AAA

Given the persistently low interest rates, investors have shown an affinity for anything that kicks off a dividend. Royalty trusts, real estate investment vehicles and equity income funds, like the iShares High Dividend Equity (ARCA:HDV), have become portfolio necessities as investors try to navigate these uncharted waters.

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One sector seeing a huge resurgence in investor interest has been the high-yield debt market. Junk bonds, or those bonds issued by "less than stellar" credit-worthy companies, have seen tremendous inflows as investors have flocked to these high yielding investments. Data provided by Fitch estimates that total retail fund flows into high-yield bonds reached $15 billion during the first quarter of 2012. That sort of insatiable demand for high-yield debt has even forced industry stalwart Vanguard to close its High-Yield Corporate Mutual Fund to new investors.

While junk's recent "hotness" has prompted some analysts to begin talking about a bubble in the sector, a dose of high-yield bonds could be exactly what a portfolio needs to navigate the current market.

Equity-Like Returns
Despite the sector's recent run-up, high-yield bonds could be the place to be over the next few years as the low interest rate environment and stock market volatility continues to play out. Putting the 1990s collapse of Drexel Burnham Lambert behind it, the high-yield sector has provided an attractive total return that has outpaced equities over the long term. Over the last 20 years, the Barclays Capital U.S. Corporate High Yield Index has managed to return more than 8.21% annually. At the same time, the S&P 500 managed to only produce a 7.81% total annual return. Likewise, Barclays' (NYSE:BCS) global measure of high-yield debt has also trounced the broad stock index over the last two decades.

Much of the reason for this outperformance stems from the sector's higher coupon payments. Simply put, firms with lower credit scores need to pay more in order to receive credit. Currently, the extra yield investors' demand to hold the riskiest sector of the corporate bond market versus safe treasuries sits at around seven percentage points. However, with the U.S. economic outlook looking better and high corporate cash balances and defaults dwindling, the junk market has actually improved in credit quality over the last few years.

With interest in the sector high, much of the future gains for the asset class will most likely come from its distribution yield. However, that 6 to 8% yield alone might be enough for investors to plow through the current low-rate, slow recovery environment.

SEE: Junk Bonds: Everything You Need To Know

Buying Some Junk
With interest rates low and volatility high, junk bonds could be just what investors need in order to navigate the current market. Both the iShares iBoxx $ High Yield Corporate Bond (ARCA:HYG) and SPDR Barclays Capital High Yield Bond (ARCA:JNK) represent the two largest exchange-traded funds (ETFs) in the sector, with assets of roughly $15 billion and $10.5 billion, respectively. The iShares ETF leads the way in terms of holdings at 601, with bonds from issuers like hospital owner HCA (NYSE:HCA) and pipeline firm Energy Transfer Equity (NYSE:ETE). Overall, the two ETFs can provide the easiest route into the junk bond space.

Like their stock holdings, most bond investors suffer from a "hometown" bias and focus strictly on U.S. investments. However, there are plenty of compelling reasons to look abroad for junk exposure. Focusing strictly on exclusively corporate high-yield debt, the new Market Vectors Emerging Markets High Yield Bond ETF (ARCA:HYEM) allows investors to bet on emerging markets' continued outperformance. Similarly, the iShares Global ex USD High Yield Corp can be used by portfolios to access the high-yield markets across developed Europe and Canada.

Finally, for those investors looking for more "oomph" from their high-yield investments, a variety of closed-end funds use leverage to juice returns and distributions. Both the Credit Suisse High Yield Bond Fund (AMEX:DHY) and Dreyfus High Yield Strategies Fund (NYSE:DHF) yield in excess of 10%.

The Bottom Line
Already a hit with those looking for income, the high-yield bond sector could be the place to find equity-like returns. For investors facing the current low interest rate environment and volatile stock market, adding a swath of these bonds might do a portfolio good. The previous ETFs, along with the PIMCO 0-5 Year High Yield Corp Bond ETF (ARCA:HYS) make great picks.

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At the time of writing, Aaron Levitt did not own shares in any of the companies mentioned in this article.

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