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Investors Should Avoid Adding New Money to Junk Bond ETFs

By: David Fabian
Posted: 3/19/2014 8:50:00 AM
Referenced Stocks: AGG;HYG;HYS;BKLN;EMB

High yield bonds, otherwise known as junk bonds, have been an excellent source of capital appreciation and income for several years now. They have benefited from the Fed’s ultra-low interest rate mandate, which has forced income seeking investors to broaden their horizons for risk assets. This in turn has prompted billions of dollars to flow into below investment grade credit quality holdings at a tremendous pace.

This risk taking mentality and low interest rate environment has allowed the junk bond market to bypass its normal cyclical nature to reach surprising new heights. Companies have also continued to take advantage of these ideal circumstances to refinance or issue new debt at excellent rates, despite their low credit scores. The bull market in stocks has also helped to prop up high yield credit which typically moves in a similar fashion to equities.

Frankly, I don’t blame anyone for wanting to seek a higher return on their assets than the 2.07% yield that an aggregate bond portfolio such as the iShares Core Total U.S. Bond Market ETF (AGG) can provide. This type of low yielding investment becomes even harder to swallow when you consider the threat of rising interest rates can quickly wipe out any marginal income that this ETF manages to produce.

The biggest ETF in the high yield fixed-income space is the iShares High Yield Corporate Bond ETF (HYG), which has more than $13 billion under management. If you look at the 5-year annualized returns of this fund through 12/31/13, you would be amazed to see equity-like gains of 15.01% per year. In fact, HYG has continued to march even higher in 2014, which has pushed the 30-day SEC yield down to a relatively meager 4.49%. When you consider that the 12-month trailing yield is noted at 5.96%, you can see just how much less income new money would receive today than it would a year ago.

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The last spat of volatility in HYG came back in mid-2013 when the Fed indicated a potential for tightening the reigns of quantitative easing and raising the Fed Funds rate. Many investors saw this as an opportunity to adjust the duration of their high yield bond holdings by moving to a shorter duration fund such as the PIMCO 0-5 Year High Yield Bond ETF (HYS).

This strategy provides a measure of security from the threat of rising interest rates and still captures a higher yield than an aggregate bond portfolio. Another popular alternative to reduce interest rate risk is the use of bank loan ETFs such as the PowerShares Senior Loan Portfolio (BKLN).

While I have been a big proponent of these moves in the past, I am hesitant to recommend that investors put new money into high yield fixed-income or bank loans at this time. The height of prices, compression of yields, and general complacency in the low credit quality arena has made me cautious about the risk to reward equation from this point forward.

If you still own high yield ETFs, I would continue to do so with the mindset that we may be closer to the end of this ride than the beginning. Prices are not indicating any kind of problem as of yet and the income streams are still solid for early adopters, however there will come a time when it will make sense to switch to higher credit quality areas such as investment grade corporate bonds or mortgage securities. I would recommend being flexible to shift your holdings in response to changing conditions when we reach an inflection point or see a convincing turn in price.

From a valuation standpoint, I still believe that emerging market bonds are offering a more attractive profile with respect to yield and price than domestic high yield fixed-income. The iShares JP Morgan USD Emerging Market Bond ETF (EMB) is currently a sector allocation in my income portfolio that is paying a yield of 5.00% and in my opinion has room for upside capital appreciation as well. Emerging market bonds certainly have their own unique set of risks; however I am more inclined to integrate new holdings that have not already climbed to all-time highs.

By making these types of adjustments you can reduce the risk of being over allocated to a stretched area of the fixed-income landscape. Staying ahead of the curve and being proactive with your portfolio will allow you to sidestep any major volatility with respect to credit or interest rates.