Junk Bond Funds Still Offer Very Attractive Yields

May. 6.11 | About: SPDR Barclays (JNK)

Junk bond funds with yields around 7½%-9% remain a prime source for obtaining relatively high yields in this low yield environment. A chart for Barclays Capital High Yield ETF is shown below. Fund managers consider it representative of junk bond fund performance and its symbol is easy to remember, JNK. Its yield of 7½% is a little lower than many other funds and the decline and subsequent recovery understates records of many others, but it does show the overall trend of funds. At its lowest prices in late 2008, the yield was around 16% (but lower than at many other funds).

SPDR Barclays Capital High Yield ETF - (click chart to expand)

Click to enlarge

Junk bond portfolios show the bonds have coupon rates around 8% and the vast majority are valued above par. Owning junk bonds is a good business. Low default rates indicate that bonds have excellent prospects for continuation of income. Primary expenses for these closed end funds are interest on borrowed money (used to buy additional bonds) and defaults. Interest expense is near zero in this low interest rate environment. Defaults go from low to lower (a major difference between this recession and prior ones).

Understanding the 3 major sell-offs in recent years is helpful when evaluating these investments. 1990 and 2000 were very difficult times for junk bonds and dividends were cut substantially, typically over 50%. I'm a long time owner of these funds and experienced those cuts first hand. Defaults on junk bonds were very high. But the financial meltdown 2 years ago was different. It largely centered around high risk mortgages, financial products that junk bond funds do not invest in. Nevertheless these funds plunged to record lows bringing the highest yields ever, many above 25%. Courageous investors who bought then to lock up high yields where rewarded.

The future for junk bonds is encouraging even with nominal interest rates near record lows. There are no other investment securities with comparable yields. Stocks with extreme yields are very risky, many times they have dividends that are not covered by earnings. In 2000 many REITs had double digit yields, today 5% is considered high. The Alerian MLP Index yields 6.2%, a few have higher yields. Utility and telephone stocks are among the highest yielding stocks, with yields over 5%.

During better economic times, such as the mid 1990s and prior to 2008, comparable nominal yields on junk bonds lasted for years. As long as recovery conditions continue, even at moderate rates, defaults should remain low and income from these funds can continue pretty much at present levels. But income is subject to risk. A continuation of low rates can lead to lower interest income. When bonds mature, that money may be reinvested in new bonds with lower rates. Eventually interest rates will rise, raising interest expense for funds with leverage, which will squeeze net investment income.

Long term track records of these closed end funds are surprisingly good. Two of mine have done well. From the end of 1999 (before the market crash in 2000), one doubled in value and the other has risen about 60%. Many blue chip stocks have not done as well. Stock prices of funds are lower because of reduced dividends, increased values are due to reinvested dividends. Moderate yields from junk bonds are not as appetizing as when they were in double digits. But 8% yields look good when compared with inflation rates under 3%.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.