HYS Offers Diversification And High Yield Exposure, But Watch That Credit Risk

| About: PIMCO 0-5 (HYS)

Summary

High yield bond funds have been under heavy selling pressure.

HYS uses fairly short maturity junk bonds and shares are influenced more by recessionary fears than movements in treasury rates.

When investing in high yield bonds, it is important for an investor to have adequate diversification.

The level of defaults assumed and priced into the fund has increased substantially.

High yield bond funds have come under heavy selling pressure since the summer months and materially lower during the first part of 2016. The PIMCO 0-5 Year High Yield Corporate Bond Index ETF (NYSEARCA:HYS) is one of those junk bond funds and a reasonable choice for exposure to securities ranging from BBB- to "Not Rated." While some of the junk bond funds may try to stick to the higher end of the "junk" range, the exposure for HYS is significantly more varied. The portfolio includes a material portion of the portfolio facing ratings of CCC+ or below.

Credit

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If investors are looking for a junk bond fund, HYS offers a fairly high yield. The performance of the fund over the next couple of years will be primarily influenced by the level of defaults on the existing holdings as well as any increase or decrease in the credit spread between junk bonds and treasuries.

Swinging For the Fences

One of the experiences that I think can be damaging to an investor's perspective is being overly exposed to the speculator's perspective. When an investor starts thinking about how to get 50% gains, they start ignoring the risk for an 80% loss. Since the individual investor is not an insurance company, it should not be his (or her) goal to match up a large portfolio and have losers offset the winners. It just isn't feasible to do sufficient due diligence and have that level of diversification.

For the investor that wants full diversification among high yield issues, buying HYS is substantially more reasonable than attempting to build a portfolio of a hundred different issues. I think funds like HYS are a perfectly reasonable option for investors that just want that diversified high yield exposure. It is certainly far better than swinging for the fences on individual junk bonds. Analyzing those issues often falls far beyond the realm of typical investors.

Using a bond fund like HYS in the portfolio is one way that investors can simply accept that there will be some level of defaults and try to overcome it with high yields and diversification in the holdings.

Maturity Distribution

The following chart breaks down the maturity distribution for HYS.

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The maturities are all fairly short so that the primary factor determining returns over the longer haul is the level of defaults on the securities. If the defaults are low, the fund will have great performance. On the other hand, if defaults are soaring due to a weakening economy, the fund can fall just as rapidly as the broader equity indexes. It is important that investors remember that junk bonds are almost a pseudo equity investment in their enormous correlation of returns with the major indexes.

The movement in shares of HYS has demonstrated almost no connection with the treasury rates. I created the following chart to demonstrate the treasury rate movements and approximate value changes for treasury holdings of given maturities.

The 3- to 5-year treasuries saw gains of $1.24 to $2.70 per dollar of face value. However, shares of HYS ended 2015 at $91.62 and closed February 17th at $87.91. The fund only went ex-dividend once during that period and the dividend was $.43. The decline in value is clear, but so far, it seems like the decline is simply a function of the fair value for bonds. When the economy is facing recession, the credit spreads start to widen and they are getting much larger for the junk bonds. As a result, HYS moved down in a manner that more closely resembles equity than treasuries or higher credit quality bonds.

Expense Ratio

The expense ratio on the ETF is .55%. This is much higher than what I'm generally willing to pay on my investments and that assessment is especially true when it comes to debt funds in a low interest rate environment.

Yield

The fund offers what appears to be a fairly high yield of 5.52%. It'll be interesting to see how sustainable the dividend payments are if there is an increase in defaults.

Outlook

In my opinion, the pullback in the market has been larger than is warranted given the relative size of the headwinds and that makes junk bond funds more attractive over the next year. If junk bond funds had not sold off in the same manner with declining equity values, they wouldn't be as appealing.

Conclusion

For a fund with an effective maturity of slightly over 3 years, the distribution yield of more than 5.5% is quite attractive because it offers enough income to help an investor actually live off the distributions from the portfolio. The unattractive feature for the long term is the high expense ratio and the potential for defaults to exceed the levels baked into the share price. From the recent sell-offs, the level of defaults baked into the price has increased materially.

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

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.

Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis.