For as good as 2013 was for stocks, it was equally bad for
#-ad_banner-#Bonds posted their lowest return since 1994.
Investment-grade bonds posted their lowest return since 1980 and
first loss since 1999. Last year was the only third year in the
past 34 that bonds closed the year with a loss.
This bout of weakness was driven by the Federal Reserve, which
in May announced its intention to taper its quantitative easing
stimulus program. That sent many investors fleeing bonds trying
to avoid rising rates.
But that would be a mistake. One group of bonds is in position
to continue bucking that bearish trend -- and deliver more than
double the yield of the 10-year Treasury.
While most classes of bonds were suffering sharp losses last
year, there was one group that was virtually immune from that
weakness. In fact, these bonds actually finished the year in the
green, making them the top-performing class of bonds in 2013.
iShares 20+ Year Treasury Bond (NYSE:
has fallen nearly 10% in the past 12 months and
iShares iBoxx Investment Grade Corp Bond (NYSE:
is down almost 1%, the
iShares iBoxx High-Yield Corporate Bond (NYSE:
has gained better than 5%:
That divergence pattern has left many investors scratching
their heads. Why are "junk bonds" performing so well in a weak
The answer is interest rate sensitivity.
High-yield bonds are issued by companies with lower credit
scores and more leverage in the balance sheet. That is an
important distinction because it makes junk bonds less sensitive
to interest rates and more sensitive to underlying economic
growth. The concept is simple: As long as the economy grows,
leveraged companies will have the earnings and cash flows to
service their debt.
That's why high-yield bonds posted a great year in 2013. The
U.S. economy grew 1.9%, and the global economy grew 3%. That
supported debt service for leveraged borrowers and lifted
high-yield bonds to a strong outperformance.
And that's exactly what's on tap for 2014. The International
Monetary Fund (
) recently increased its 2014 growth projections to 3.7% for the
world economy in 2014 and 2.8% for the U.S.
Here's something else to consider. The private sector has
never been stronger. Earnings, cash balances and margins are all
at all-time highs. Even companies with lower credit scores are as
financially strong as they've ever been. That means it's a great
time to own high-yield corporate bonds.
Both are bullish signals. Because with investors desperately
searching for yield in a low-yield market, high-yield bonds
cannot be ignored.
The iShares High-Yield Bond is an exchange-traded fund (
) that is linked to a high-yield bond index. One of the most
popular ETFs (particularly among bond funds), HYG ranks as one of
the top 50 ETFs, with assets under management of $15 billion.
HYG is a great fund for diversified exposure to high-yield
bonds. Being linked to an index has the fund holding 884
high-yield corporate bonds. Its top 10 holdings account for just
3.9% of total fund assets, adding further diversification.
HYG is a junk-bond ETF, but it is hardly made up of no-name
companies with little brand recognition or financial strength.
Its top 25 holdings are loaded with familiar names, including
Sprint Nextel (NYSE:
Icahn Enterprises (Nasdaq:
Tenet Healthcare (NYSE:
. These are companies with strong operating histories that
benefit from high barriers to entrance. That supports consistent
Investors are well compensated for accepting the extra credit
risk that high-yield bonds carry. HYG is currently yielding 6.2%,
more than twice the 2.9% yield on the 10-year Treasury.
HYG also scores well on expenses. Its expense ratio of 0.50%
is in line with its category average of 0.48%.
The Options Trade Setup
Options are most commonly associated with stocks. But with ETFs
offering access to a wide range of markets, options offer another
strategy to cash in.
As an asset class, bonds (fixed-income) is less volatile than
stocks. And because volatility is the most important factor when
trading options, we will need to adjust our parameters
Most of the time when I sell puts, I use strike prices that
are 10% to 15% out of the money. That's a conservative threshold
that reduces the probability of actually being put shares.
But because bonds are generally less volatile than stocks, I
am going to adjust my strike closer to the money. That will
increase the size of the premium I collect while still carrying a
low probability of being put shares.
I'm also going to push my expiration to the long end of my
target range between 45 and 60 days. Selling March puts instead
of February puts increases my premium payment to $35 instead of
just $10. Taking a longer-dated expiration also increases the
probability of being put shares, but since I'm bullish on
high-high bonds and HYG, I'm confident prices will continues to
advance in the next few months as the economy accelerates into
Action to Take -- >
Being put 100 shares of HYG at a strike price of $90 would
require a $9,000 investment. But to initiate this trade, I won't
need the full amount. Most brokerage firms require a 20% deposit
to control the position. That puts my margin deposit for the HYG
trade at $1,800. Here's how the trade looks if the options expire
worthless. As you can see, this is a high-probability trade, with
a 98% chance of our options expiring worthless. A potential 1.1%
return in 60 days compounds out to a potential 8% gain in 12
months, without buying a single share of HYG.
Here's how the trade looks if we are put shares: