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by JT

January 2013 was marked with the concept of a "Great Rotation" from fixed income to stocks. The premise is simple: after more than 30 years of a bull market in bonds, investors buying today are buying at record low yields. Relative to 2% on a 10 year treasury bond, a dividend-paying stock at a fair multiple seems like an incredible bargain.

This rotation is more than a simple change in stocks and bonds, however. It's a rotation from low-risk assets to riskier assets, all in the pursuit of yield. For instance, the best-kept secret of the individual investor, MLPs have been on fire and we've even seen utility ETFs and mortgage REITs garnering interest in recent years when they used to be primarily chased by retirees seeking yield.

What's Up in Junk Debt

The market for junk debt is growing faster than anyone could participate. Low returns on fixed income of all types brings new people to the market who might have never, ever thought about owning anything lower than BBB- before.

There are a few interesting developments in the space thanks to large capital inflows:

    1. Low default rates - According to data from Standard and Poors, the default rate on junk debt is well below historical norms. The ratings agency notes that defaults are coming in at 2.7% versus a historical average of 4.5 percent. S&P expects that defaults will rise modestly to 3.5% in 2013. Low default rates are partially driven by lower rates on the whole as well as appetite for yield, as companies find it easier to refinance junk debt with new issuance. Distressed debt investors are concerned about the lack of companies facing difficulty in raising capital, a sign that credit is flowing freely.
    2. ETFs focus "hot money" in junk debt - ETFs are known as diversified investment vehicles, but they aren't perfect. We'll touch on this later, but junk bond ETFs are far more concentrated than the total junk bond market. This is due to practicality (the junk bond market isn't very liquid) and investor preference (good diversification is often good enough).
    3. Long dated money is displaced - The Fed's active MBS purchase program shifts investment capital from long-dated mortgage backed securities into other fixed-income products. Investors willing to accept longer maturities for a higher yield-to-maturity either have to step up the risk chain or tolerate yields that barely cover the rate of inflation today, let alone the potential inflation rate 10 or 20 years from today. Assuming the Fed will eventually stop its bond buying spree, capital could flee the high yield markets.

Playing it Safer

The primary junk bond funds include the SPDR Barclays Capital High Yield Bond ETF (NYSEARCA:JNK) and the iShares iBoxx $ High Yield Corporate Bond Fund (NYSEARCA:HYG), but these two funds are very different from one another, and the junk bond market as a whole. We'll also include one market-beating small active fund, the Peritus High Yield ETF (NYSEARCA:HYLD).

First, let's discuss the investment universe. Standard & Poors issues ratings on more than 1,400 junk bonds. However, JNK and HYG hold only 433 and 730 issues respectively. At best, investors have exposure to only half of the junk bond market through these two basic index funds. The Peritus High Yield ETF (HYLD) shops the total junk bond market, but management has invested the fund in only 59 issues.

When Active Management Pays Off

The differences in credit quality are relatively unimportant in comparing these three funds. Returns and average maturities, however, differ in a big way:

    • The Peritus High Yield ETF (HYLD) offers a portfolio with a 9.58% yield to maturity with anaverage duration of only 3.22 years.
    • The SPDR Barclays Capital High Yield Bond ETF (JNK) has a yield to maturity of 6.31% and an average maturity of 6.78 years.
    • The iShares iBoxx $ High Yield Corporate Bond Fund (HYG) brings an average yield to maturity of 5.52% with a weighted average maturity of 4.43 years.

In short, the actively-managed Peritus fund has a higher expected return, a lower average duration (and thus less rate risk), with the added benefit of active management.

Despite being more costly at 1.35% per year, the Peritus fund looks to be the best value. The expected returns are higher, rate risks are lower, and active management can avoid buying losing issues just because they're part of the index. If it weren't for the fund's small size, excess returns would be an impossibility, but for as long as this remains the smallest fund in the space, it should be an investor's first choice. Active management will likely pay off doubly when the junk debt boom turns to bust.

Disclosure: No position in any ETFs mentioned here.

Source: Junk Bond ETFs: Adjusting For 'The Great Rotation'