With default rates continuing to trend near historical lows, high yield bonds continue to provide attractive yields for aggressive fixed income investors with relative safety of principal. Of course high yield, or junk, bonds, as they are at times affectionately referred to, represent a loan to enterprises with a weaker balance sheet and/or line of business compared to investment grade counterparts. The risk of high yield bond funds, while seemingly dormant for the time being, should not be underestimated by the average retail bond investor.
While a group of individual issues could present a high-yield allocation solution for sophisticated investors with credit analysis expertise and comfort with the potential perils involved, my advice for most investors remains to allocate through a pooled product such as an ETF or CEF (closed-end fund). Though you will see a portion of your money eaten up through ongoing management fees, I feel the instant diversification presented by a bond fund is a small price to pay for the potential disaster that a highly concentrated individual issue portfolio might represent in a recessionary climate or random increase in defaults.
If you have $100,000 to invest towards junk bonds and think that 10 positions with $10,000 in each is adequate diversification, I’d think again. With hundreds of holdings, ETFs and CEFs represent a more sensible solution for investors without the time or inclination to independently research the junk space.
I see basically three sound options for high-yield investors looking at the breadth of pooled products traded on market exchanges. Broken down they are:
- Liquid ETFs like HYG and JNK
- A closed-end fund trading at a discount to net asset value
- A defined maturity ETF from Guggenheim maturing in an appropriate year
The “best” way to play high-yield is somewhat in the eye of the beholder. HYG and JNK are very similar vehicles with yields in the 6% range, blended credit in the low BB – high B range, and around 4 year duration. Closed-end funds vary widely in composition with yields anywhere between 7 and 11 percent, variable duration, and most with added leverage, which boosts yield, but can also boost the risk proposition of the vehicle. The Guggenheim Funds seem to lag a bit on the yield front, but seem to possess similar credit profiles to that of both HYG and JNK.
From a capital preservation perspective, despite a somewhat unpredictable level of return which I discussed in a previous article on the Guggenheim ETFs, a defined maturity product makes a lot of sense. In a rising rate environment which is a very real risk today, even funds with limited duration like HYG and JNK pose capital peril, whereas a defined maturity product provides more capital return clarity.
In the end, I suppose the decision on which type of product to utilize comes down to personal preference, risk tolerance, and a personal take on the forward macroeconomic environment. If you think both interest and default rates stay low, then perhaps an aggressive closed-end fund with leverage makes sense. If you are inclined to think that rates start to trend higher over the next 12-18 months, then the defined maturity angle might present the best solution. For others without a definitive take, HYG and JNK, which are widely considered to be all-weather high-yield products, might be a good middle-of-the-road, liquid alternative.
Whichever route you choose, bear in mind that despite the relative near-term, innocuous risk profile, there is a reason that high-yield bonds bear the “junk” moniker. So while investors continue to receive their junk coupons, don’t fall prey to the blase attitude that nothing bad can happen to high-yield bonds.
About the author:
Adam Aloisi has over two decades of experience investing in equities, bonds, and real estate. He has worked as an analyst/journalist with SageOnline Inc., Multex.com, and Reuters and has been a contributor to SeekingAlpha for better than two years. He resides in Pennsylvania with his wife and two children. In his free time you may find him discussing politics, playing golf, browsing antique shops, or traveling.