Junk Bonds Offer Attractive High Yields In A Low Interest Environment

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 |  About: SPDR Barclays Capital High Yield Bond ETF (JNK)
by: Avi Morris

With the announced plan by the Federal Reserve to continue low interest rates, high yield bonds have value for those who want to raise income. Their 8-10% yields far exceed yields on other investments. For example, investment grade corporate bonds typically yield roughly 3-5%, as do REITs, MLPS yield roughly 6-7%, and most stocks yields less than 4%. However the credit ratings on high yield bonds are below investment grade quality, so extra care must be taken before investing.

High yield bonds funds (junk bonds) have had fairly steady prices for about 2 years until the sell-off in August. Barclay's Capital High Yield Bond ETF (NYSEARCA:JNK) is representative of the junk bond fund industry with a symbol, JNK, that is easy to remember. But its yield of 7% is below yields available on many other junk bond funds. After little movement for 2 years, JNK plunged in August from 40 to below 35. Since then, its rebound has largely recovered that loss; fundamentals for the high yield industry have not changed.

Barclay's Capital High Yield Bond ETF (JNK) Click to enlarge The key metric for junk bonds is the default rate. By all measures, it is low (around record low levels), and defaults are expected to continue at low levels. Bond prices recovering their their values from before August reflect this favorable trend. Bonds in the portfolio of these funds typically have coupons of 8-9% and are valued at premiums over par value. Demand is strong for junk bonds; investors have been eager to purchase large quantities of new offerings. Current yields of 8-9% on junk bonds are 6-700 basis points above the yield on the 10 year Treasury bond. Extra yield is required, as the reward for a substantially higher business risk.

The spread compares with roughly 450 basis points during the best of times. A wider spread is one measure of a better value when compared with the long term trend. The track record of junk bond funds is reasonably good, and investments in these funds have done well. I have had investments in these funds for many years. In recent years, the 3 bad periods were around 1990, 2000 and late 2008. They were bad, especially the last one, when interest rates soared to over 25%. But junk bond funds recovered. For example, my investments in junk bond funds are up around 40% since the start of the last recession in December 2007. That shows the importance of reinvesting dividends. During the worst months in early 2009, my fund dividends were buying twice as many shares as in 2007.

The comparison with the Dow is favorable. In late 2007, the Dow was around 13,000, and subsequent dividends were nominal. Present conditions for junk bonds (low Treasury interest rates and very low default rates on junk bond debt) could last for a considerable amount of time, as was the case before 2008. When the economy recovers, higher interest rates will change junk bond fundamentals for the worse. But those conditions could be a few years away, given the Federal Reserve's intention to keep low interest rates for at least 2 years. Demand for new junk bond offerings should continue. Low default rate on junk bonds will allow dividends to be maintained with little or no slippage during the coming months. Investments in junk bonds are generally limited to about 10% of a portfolio. But for those looking for extra investment income, junk bond funds should be considered.

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