High Yield Junk Bond ETF: Risk/Reward Spectrum Favor Buying?

by ETF Base on March 24, 2010

Given the current low interest rate environment and the seemingly unchecked momentum in common equities since last March, investors may want to consider parking some portion of their allocation in high yielding vehicles in the event the market takes a breather.  There are some decent ETFs out there that combine high yield, sustained dividend payouts and diversification across companies and sectors.  Here, I’m reviewing the one at the extreme of the risk/return spectrum of high yield bonds in that the portfolio consists solely of debt issues from companies with middle to low credit quality.

Ticker: (JNK)
ETF Name:
SPDR Barclays Capital High Yield Bond
High Yield Corporate Bond

Aptly symbolized (JNK), this ETF holds corporate debt instruments commonly referred to as junk bonds.  As we’ve all probably learned the hard way at some point or other, higher yield and/or higher expected returns generally comes with higher risk unless you’re privy to some sort of asset class that others aren’t.  This class of issues presents a higher risk of default compared to even highly rated high yield blue chips in the 5-6% yield range, but investors have continued to pour money into high risk debt seeking diversification out of no interest Treasuries and stocks that have run 70% from their lows.  As this Bloomberg article highlights, the pace of investor dollars pouring into this asset class continues to be brisk with no signs of abating.

What’s driving the interest in Junk?

Well, the economic Armageddon which was widely hailed as plausible in 2008 and 2009 did not come to fruition and at least a mild economic recovery is underway and is widely expected to continue.  The odds of a double-dip Recession are now broadly discounted and in the face of the administration’s appetite for bailouts and governmental intervention combined with a distaste for eating a sunk cost even on a lost cause (how long did they throw money at an inevitable GM bankruptcy?), the prospect of a massive wave of corporate defaults is somewhat mitigated.  Another interesting statement came Wednesday from bond king Bill Gross (via CNBC) where he stated that he now likes equities over bonds.  My take was he was slamming Treasuries primarily, not so much corporate debt, based on his statements regarding the recent health care legislation and the future impact of these new entitlements on the country’s ability to meet future debt obligations at a reasonable interest rate.

The credit quality of the JNK portfolio holdings are generally BB and below and issues range from Financials to Industrials and beyond.  Some positives include the broad diversification across various sectors and a monthly dividend payout.  While the payout has declined in recent months, a frequent payout allows for monitoring and less volatility than a quarterly announcement that shocked investors, not to mention a quicker turnaround time to put that cash to work.

A common risk to high yield investments is interest rate risk, but given signals from the Fed and prospects of high single digit unemployment for several years to come, it is unlikely there will be the kind of wage growth and consumption pace to drive higher inflation mandating rate increases.  If anything, increases will likely be muted and sporadic as opposed to a rapid increase to mid single digits, which would of course, have a tangible impact on the attractiveness on income investments such as high yield muni bonds and preferred stock ETFs which have fared quite well over the past year as well.

Disclosure: No position in JNK.

{ 2 comments… read them below or add one }

Daddy Paul March 24, 2010 at 8:51 pm

I think this is a good time for junk bonds. Most of the companies that are going belly up have gone belly up. I like ETF’s but high yield is one area a managed fund is probably a better deal.


chad March 31, 2010 at 12:34 pm

I have to say, I am not really sold on the idea of Junk bonds right now. especially when you consider all thats going on.I wouldn’t be to keen about what Gross has to say either.


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