Given the persistently low interest rates, investors have shown a penchant for anything that kicks off a dividend. Master limited partnerships, 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.
One sector seeing a huge resurgence is the high yield debt market. Junk bonds, or those bonds issued by "less than stellar" credit-worthy companies, have seen inflows of almost $12.6 billion since the beginning of the year. Given the continued low interest rate/yield environment, some analysts predict that junk's best days may still be ahead. For investors, adding a dose of high yield bonds could be exactly what a portfolio needs.
Big Gains in 2012
So far the high-yield bond sector has gained 4.85% this year, as investors continue to strive for yield. However, a variety of analysts predict the sector could see total returns as high as 14% for the full year. The reason: better global economic data. Since companies that issue junk bonds have spotty credit scores and their returns are highly correlated with economic health.
In the U.S., the Philly Fed's general economic index recently increased to 10.2, beating analyst forecasts of 9. In addition, all important housing data has finally begun to turn a corner, and jobless rates have fallen to 8.3%. In Europe, the situation in Greece seems to be contained for now. This has helped junk bonds slide into a low default rate of just 2%. According to ratings agency Fitch, that's well below the historical annual default rate of 5.1%.
This improving situation, coupled with historically low interest rates, prompted J.P. Morgan (NYSE:JPM) to raise its estimates for high yield bond's full year total return to 13.7 from 9.4%. Overall, head credit strategist for the bank, Peter Acciavatti, said in a research note, "The brighter macro picture augurs the case for the rally in high yield extending and the low yield environment being sustained."
Given the sector's rise so far this year, much of its future gains will most likely come from its distribution yield. Junk bond yields can currently be had for around 6.11 percentage points over similar maturing Treasuries. This is near historic averages. However, that yield alone might be enough for investors to plow current low-rate, slow recovery environment.
It's not all Junk
With interest rates still at low levels, junk bonds could be just what investors need to add a little yield to their portfolios. To minimize the risk of default, investors should take a broad approach. The exchange traded boom has made it easy for investors to add a wide swath of the binds to a portfolio via one ticker. Here are a few picks.
With $14 billion in assets, the iShares iBoxx $ High Yield Corporate Bond (ARCA:HYG) is the largest fund in the sector. The ETF spreads those assets around, holding 500 different junk bonds from issuers like utility Calpine (NYSE:CPN) and telecom giant, Sprint (NYSE:S). The iShares fund has healthy 7.45% distribution yield and charges 0.50% in expenses. Likewise, the SPDR Barclays Capital High Yield Bond (NYSE:JNK) has $11.8 million in assets and features a slightly more concentrated portfolio at 224 holdings. The SPDR yields 7.36%.
While junk bonds are not necessarily affected by rising interest rates as much as regular bonds, they still feel some effects. In addition, defaults can and do happen. For investors worried about these things, shorter duration high yield bonds may be in order. The PIMCO 0-5 Year Hi Yield Corp Bond ETF (ARCA:HYS) uses a sampling technique to pick its holdings and currently features an effective maturity of just 2.48 years. The ETF yields 5.93%. Also offering investors the ability to tailor their maturity profiles, is the Guggenheim's Bullet Shares suite. The Guggenheim Bullet Shares 2013 HY Corp Bond (ARCA:BSJD) and Guggenheim Bullet Shares 2014 HY Corp Bond (ARCA:BSJE) feature portfolios of bonds that will mature in their respective years and could be used to soften the blow of rising rates. These ETFs still yield a market beating 3.69 and 4.49%, respectively.
The Bottom Line
Given the low interest rate environment and a brighter economic picture, the high yield bond sector is seeing its star shine. Already up nicely in 2012, analysts predict that bigger gains could be on the horizon. For investors, adding a swath of these bonds might do a portfolio good. The previous ETFs, along with the PowerShares Fundamental High Yield Corp (NYSE:PHB) 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.