These 2 Undervalued High-Yield Picks Are Poised For A Rebound

Includes: BKT, HYG, SJNK
by: Hawkinvest

As most investors know, bonds have dropped in value due to a rapid rise in interest rates. The rise in rates coincided with comments by Ben Bernanke about two weeks ago which raised concerns that tapering would begin later this year, if the economy improves further. That seems like a big if, and the spike in interest rates is now likely to considerably cool off the two sectors that have been showing strength: housing and auto sales. Without the low financing rates consumers enjoyed this Spring, these two main drivers of economic growth could take a big hit and that means the economy and interest rates might soften again. This would likely cause Bernanke to postpone the tapering plans and that could lead to a significant rebound for bonds. With this in mind, here are two picks to consider buying now for high yields and strong rebound potential:

BlackRock Income Trust, Inc. (NYSE:BKT) is a closed end fund or "CEF" that seeks to provide shareholders with both preservation of capital and high monthly income. It invests in highly rated bonds which greatly reduces credit risks for investors. This fund is managed by BlackRock which is an industry leader and the fund has a long track record of providing returns for investors ever since it was started in 1988.

The BlackRock Income Trust is an ideal way to play a potential rebound because it offers a generous yield of nearly 7%, it is oversold, and it appears very undervalued as it sells at a significant discount to net asset value. The fund pays a monthly dividend of 3.7 cents per share. As of July 9, the net asset value or "NAV" is $7.38 per share which means the fund is currently trading at a discount of almost 11%. In the past 52-weeks, it has traded at a discount of about 4.65% on average. With the discount now at more than twice that level due to the sell-off in bonds, investors who buy now could see strong gains. A rebound could take these shares back over $7, if it were to trade for the historical discount to NAV rather than close to the current level, which is a record. Take a look at the chart below and you can see that oversold levels have been reached:

(Click to enlarge)

This fund does not appear to deserve the sharp sell-off to current levels for a number of reasons. First of all, as discussed above, it is now trading at a historically wide discount to net asset value. Furthermore, the fund portfolio is primarily made up of high quality securities, and about 98% of the holdings are rated "AAA". In addition, the option-adjusted duration is just 3.63 years. This greatly reduces duration risks for investors and it is another reason why the sell-off in this fund appears excessive. While liquidity and leverage risks exist for any fund like this, the risks appear relatively low due to the high quality and short duration of its portfolio. When investors sell a closed end fund like this excessively, it can create a solid buying opportunity which is what we appear to have now based on the yield, discount to net asset value and the high quality portfolio. I believe interest rates will gradually cool off with the economy this Fall, and that could push these shares much higher. However, even if rates don't head lower and only stabilize at current levels, this stock could still head back over $7, as the discount to net asset value narrows as it has in the past. In the meanwhile, investors are rewarded with a generous monthly dividend. It's worth noting that this fund has a strong track record and it has provided annual returns of about 8% over the past 5 years.

Here are some key points for BKT:

  • Current share price: $6.64
  • The 52 week range is $6.34 to $7.74
  • Earnings estimates for 2013: n/a
  • Earnings estimates for 2014: n/a
  • Annual dividend: 3.7 cents per month, which yields about 6.8%

iShares iBoxx High Yield Corporate Bond (NYSEARCA:HYG) is an exchange traded fund that primarily invests in high-yield bonds. Exchange traded funds or "ETF's" typically trade close to net asset value and this one offers liquidity due to the high volume it trades on a daily basis. This fund pays a monthly dividend and the current yield is about 6.6%.

After the recent correction, junk bonds in general appear to be undervalued. As the chart below shows, this ETF has seen a sharp selloff from about $95 per share to around $91:

(Click to enlarge)

Even though this ETF has started to rebound from recent lows, it could be poised for additional gains. Since an improving economy can cause interest rates to rise, this is good news for junk bonds because economic growth usually leads to higher credit quality for junk bond borrowers and default rates can drop.

Another positive that some investors might have missed is that junk bonds typically have a much shorter duration, often 5 to 6 years. Compare that to municipal bonds which often have 15 to 30 year durations, and you can see why junk bonds have less interest rate risk. (Investors who want the shortest duration possible can consider another ETF offered which is called SPDR Barclays Capital Short Term High Yield Bond ETF (NYSEARCA:SJNK). By contrast, junk bonds do have higher downside risks when compared to muni bonds in the event of a recession. However, with housing and auto sales showing continued strength, a slowly improving economy seems more likely. For these reasons, this ETF looks attractive now and especially on any further pullbacks.

Here are some key points for HYG:

  • Current share price: $91.50
  • The 52 week range is $88.27 to $96.30
  • Earnings estimates for 2013: n/a
  • Earnings estimates for 2014: n/a
  • Annual dividend: about 48 cents per month, which yields 6.6%

Data is sourced from Yahoo Finance. No guarantees or representations are made. Hawkinvest is not a registered investment advisor and does not provide specific investment advice. The information is for informational purposes only. You should always consult a financial advisor.

Disclosure: I am long BKT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.