Junk bonds are hot right now.
Want proof? Look at the billions of dollars that have poured into the most popular high-yield bond ETFs since 2011.
Or how about the fact that the number of high-yield bond ETFs keeps multiplying? There are now 34 high-yield ETFs, up from only four at the beginning of 2011.
Truth is, junk bonds are so hot that "high yield" is becoming a bit of a misnomer.
Benchmark yields are now 5.73%, hovering just above their historic lows.
Take a look…
(click to enlarge)
One of the most popular high-yield ETFs out there, the PowerShares Senior Loan Portfolio (BKLN), is yielding even less at 4.3%.
Introduced in 2011, this ETF holds leveraged loans, which are usually floating-rate instruments - and thus protect an investor from potential increases in market interest rates.
This protection from rising rates is a common sales pitch by brokers and talking heads on CNBC. But don't be fooled. The credit risk remains.
You may be asking, "If these corporate bonds are risky, and the compensation for owning them is near historic lows, then why are people still buying them in droves?"
Good question. Because they shouldn't be! (And neither should we.)
Here are three reasons why…
Bond Warning #1: Yields May Seem Great, But Losses Could Be Even Greater
Collecting a monthly distribution from your favorite junk bond ETF when money markets are paying next to nothing may make you feel like you're pulling off an income coup. But do I really have to remind you of what happens when things go wrong in the credit markets?
High-yield investors got slaughtered in 2007 and 2008 as the financial crisis unfolded. Defaults rose, yields spiked and junk bond prices collapsed. Late 2011 was no picnic, either.
Many people have short memories. That doesn't mean we should, too.
High-yield bonds are issued by highly levered borrowers, so they're riskier than investment grade bonds. Always know what you own!
Bond Warning #2: Fed-Induced Buying
Federal Reserve policies are inducing a massive search for yield and risk.
Don't just take my word for it…
Fed Governor Jeremy C. Stein warned in early 2013 of the "fairly significant pattern of reaching-for-yield behavior emerging in corporate credit."
Judging from our two charts above, his fears have materialized thanks to quantitative easing and the Fed's zero interest rate policy.
We look for high returns. But now we're faced with higher risk and lower reward because of the ongoing yield chase in this income-starved market. Especially in junk bonds. No thanks!
Bond Warning #3: Popular/Crowded Trades Seldom End Well
We don't want to be left scrambling to find the exit in a crowded theater when someone yells, "FIRE!"
Perhaps your neighbor, coworker, or a friend has boasted about the 6% yield he or she enjoys with the SPDR Barclays Capital High Yield Bond ETF(JNK), or the iShares iBoxx $ High Yield Corporate Bond ETF (HYG).
And maybe you even bought some because you felt like you were missing out. Admit it!
Following the herd and buying the hottest stock or ETF isn't the answer to outperforming the market, though.
Instead, we need to stay disciplined. When greed or fear has reached an extreme level, we must keep a contrarian mindset. Otherwise, we'll get burned. Badly.
Offense Wins Games, But Defense Wins Championships
If high-yield bonds are so risky right now, what should an income investor do?
In short, get defensive.
We need to resist the temptation to buy what everyone already owns (junk bonds). And seek opportunities the crowd is ignoring (like preferred securities).
Preferreds with juicy yields are currently more attractive than high-yield ETFs, which generally yield 4% to 6%. Take, for example, these trust preferred securities, yielding around 7%.
It wouldn't be a bad idea for us to also start looking for companies in safer, out-of-favor industries such as utilities, healthcare and consumer staples.
If you personally don't have the time to do the research on individual opportunities, don't fret. In the upcoming weeks, we'll be focusing on helping you protect your hard-earned money while still maintaining a steady stream of income. And we'll be providing specific actions to take along the way, too.
Additional disclosure: Dividends & Income Daily is a team of financial researchers. This article was written by Louis Basenese, one of our financial researchers. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article.