The Power of Words: High Yield Versus Junk


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The broad, long term effects of Fed policy over the last five years as the U.S. has emerged from the credit crisis cannot yet be known. Some continue to speculate that, at some point in the near future, all of the cash injected into the system will cause runaway inflation. I don’t subscribe to that theory, if for no other reason than that there is no sign of that yet; core inflation remains fairly stable and there is no indication of undue upward pressure on wages. Others talk of a bubble in asset prices that will lead to an inevitable, painful crash. That may have more validity, but in a more specific sense than most think of it.

Stocks look, by conventional valuation metrics, to be fairly valued, maybe a touch expensive on a trailing basis, but hardly the stuff of bubbles. Ultimately it is corporate profits that will drive equities and despite some high profile misses, this earnings season has so far, on aggregate, continued the remarkable run of increasing profitability that we have witnessed over the last few years. The real potential for trouble as I see it is in the continued search, maybe even stretch, for yield.

The Fed’s policy of Quantitative Easing has had the desired effect of depressing interest rates and, in the aftermath of a credit crisis, that is not a bad thing. As with many things in life, though, it is the unintended consequences that produce the risk. In this case it is the simple fact that, as a huge number of baby boomers begin to retire there is a growing percentage of investors whose main need from their investments is income. With interest rates on high grade debt and CDs so low, that has led to many looking to alternative means and in that search, taking on more risk.

That is fine, as long as that risk is understood. To me, one of the signs that it really hasn’t been is the decrease in the use of the term “junk bonds” to refer to low quality bonds. Instead, the most commonly used term has, until this last week or so, been “high yield.” This sounds good, right? I mean, what can be wrong with investing in high yield? To a baby boomer who began planning for their retirement when 7 or 8 percent was the expected return on income producing investments, around 3 percent income is not just scary, it is almost impossible to live on. Double that on “high yield bonds” looks like a logical place to be. If we return to more general use of the term “junk”, though, the inherent risk of those instruments is more obvious. That word has been re-appearing in the last few weeks as the value of those bonds has taken a sharp downward turn and the risk of junk bonds has become apparent.

To illustrate the power of words, take a look at an anomaly that exists between the two largest junk bond ETFs by assets, the iShares iBoxx High Yield Corporate Bond Fund (HYG) and the SPDR Barclays Capital High Yield Bond ETF (JNK). Both of these fund companies are large and well known with efficient sales and marketing staff and both date back to 2007, so, all things being equal, it would be logical that the most popular would be the one with the lowest expense ratio, highest yield and/or the best performance numbers.

HYG has an expense ratio of 0.50%, a 5.33% yield and a 15.39% annualized 5 year return. JNK, a 0.4% expense ratio, a 5.39% yield and a 16.99% 5 year return. By all measures, JNK looks like the better investment, yet HYG, with $11.7 billion of assets, is around one third larger than JNK, with $8.8 billion. It strikes me that the most obvious reason for this discrepancy is the fact that it is a lot easier for a broker to sell a client a fund whose ticker suggests “high yield” than one that reminds the potential buyer that what they are buying is known as “junk”.

None of this means that you shouldn’t hold junk bonds as part of a diversified income producing portfolio. The key here though is the word “diversified”. The risk inherent in low grade bonds means that spreading that risk with a mix of investment grade bonds, REITs, MLPs and dividend stocks, for example is only prudent, even if it means a slight reduction in overall yield. Simply put, yield is always a return for risk and the higher the yield, the higher the risk. Using the term “junk bonds” rather than “high yield” would help investors to better understand that, and leave them better equipped to withstand the kind of volatility we are currently witnessing.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

This article appears in: Investing , Bonds , Investing Ideas , US Markets
Referenced Stocks: HYG , JNK

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