When it comes to high yield corporate bonds the word junk doesn't accurately describe the current environment. According to Moody's the default rate on corporate junk bonds fell to 1.8% in the fourth quarter, down from 2.0% in the third quarter.
I am a numbers guy and that tells me the risk of picking a junk bond that defaults is not high. To lower the risk of investing in an individual corporate bond there is the option of high yield corporate bond ETFs.
The average high yield corporate bond is paying approximately 7% annually. When compared with the 1.95% yield on the US 10-Year bond it is hard to argue with the junk bond sector. And think about the US government, are they really much better off than some of the companies that are considered junk status by the ratings agencies?
Junk ETF Options
The two largest ETFs in the sector are the iShares iBoxx High Yield Corporate Bond ETF (HYG) and the SPDR High Yield Bond ETF (JNK). HYG is made up of over 450 positions and JNK has 222 individual bonds. This is key because it provides instant diversification for investors concerned about a possible default.
The 30-day SEC yield for HYG is 7.34% and JNK pays out 7.48%. The expense ratios are similar with HYG charging 0.50% and JNK slightly lower at 0.40%. The average maturity for HYG is 5.2 years versus 6.8 years for JNK.
Both ETFs were down slightly in 2011 before taking into consideration the monthly dividends that investors received. With defaults expected to remain low for the sector and not many other choices for high yields, I expect HYG and JNK to continue attracting new money. Not only are the yields very high, there is a good chance of capital appreciation for the two ETFs.
If I had to choose between the SPDR S&P 500 ETF (SPY) and one of the two ETFs mentioned it would be a tough decision. When risk is factored into the equation I would likely choose a junk bond ETF for the next 12 months. We could be in store for another volatile year that ends with little movement and the two ETFs will at least offer a solid monthly dividend payment to appease investors.
Disclosure: I am long JNK.