Why buy junk bonds? The Fed has made much to do about keeping rates low until 2014. You would think that with all of the talk from the global macro players that one should jump head first into long-dated bonds. What the pros aren't telling you is that most expect a small but meaningful rise in long-term rates. Understand that if the 10-year treasury goes from 2% to 3%, nobody will care from the top down. Meaning, the housing markets will not collapse, the U.S. or ECB will not implode. However, investors holding long-dated bonds will take a haircut on their brokerage statement. For instance, every 1% increase in the 10-year treasury will decrease the value of TLT about 12%-14%. All of this for an annual coupon of around 3.3% doesn't sound too safe, does it?
Investors are facing a conundrum. Do they go out on the long end and face significant principle loss or take more credit risk? We think the risk of high-yield bonds is less than the disaster we know as 2008. Corporate balance sheets are cash rich and profits are higher than ever. Okay, Kodak bit the dust, and American Airlines hit the bricks. Really? Like you didn't see that coming? The most rational approach to junk is to buy a basket of lower credit quality bonds and diversify your risk.
Now let's take it to another level. Why can't we have short duration and high yield? Cake and eat it too? On some level yes, but the tradeoffs are real. We start by analyzing the characteristics and performances of two high-yield bond ETFs - JNK, the SPDR Barclays Capital High Yield Bond ETF, and BSJF, the Guggenheim BulletShares 2015 High Yield Bond ETF. JNK is the standard ETF that traders will flock to when looking for quick and easy exposure to a high yield index. This is the same idea when you buy SPY to get broad equity exposure. To be fair, BSJF is a newly designed product that has less volume and very much a niche product for those who do their homework or get sold stuff they don't understand. No judgments there, I need people to buy and sell stuff so I have liquidity. What do I care if they know what they are doing? Okay, I am being half sarcastic, but only half.
When comparing the funds' holdings, we find that as of February 26 JNK has 201 holdings versus BSJF's 106. 85.31% of JNK's bonds have a rating of B- or better, and 14.68% of the portfolio is allocated to garbage rated CCC+ or lower. In the BSJF portfolio, 81.40% of securities are rated B- or better and 18.60% of the portfolio is allocated to bonds rated CCC+ and lower. Furthermore, JNK has a duration of 4.35 years whereas BSJF has 63% of that duration with 2.73 years. JNK has a 12-month yield of 7.50% versus BSJF's 4.89%. So, BSJF has half the holdings, though over 100 are diversified enough for our purposes. Credit for both is squarely in the mediocre quality B area, with less than 20% in the more daring CCC ratings. The real edge presents itself if you have a concern about duration. BSJF has about 40% less duration. We would hope that this would give us the added bonus of lower volatility compared with both JNK and SPY.
Let's take a peek at how the incorporation of junk bonds into a portfolio can alter its characteristics. Why is this important, you ask? Correlation! Including a junk bond ETF in your portfolio decreases the diversification effect of your portfolio. Over time we usually see around a 60% correlation of the junk bond universe compared with a mostly negative correlation with investment grade bonds to the S&P 500. Always remember that correlations change over time. That being said, investors should expect a more positive correlation with junk going forward regardless of where it might be today.
Now we have a known issue, and a solution. We started off looking to gain extra yield during a period of time we think yields will remain low, but could jump up a little. Second, we want our high yield not to seriously impact the diversification effect on our fixed income side. In English, it doesn't do us any good to chase some yield if that part of our portfolio is just going to correlate to the stock side. If that were the case, we should just buy more stocks. Now the rubber meets the road. Let's take a look at the volatility of these junk bond ETFs in relation to SPY, and how they acted during the most recent stock and credit blowup: August 2011.
So while junk bonds still correlate positively to the stock market during a crisis, BSJF had a smoother ride during this volatility stricken market when compared with JNK, the standard junk bond ETF. We calculated volatility for BSJF and JNK from August to December 2011, using continuous compounding of daily-adjusted price changes. BSJF was half as volatile (5.63%) as JNK (11.52%) during this turbulent period in the stock market. This gives the impression that BSJF is a more moderate way to play a dangerous game. It's like going to McDonald's (MCD) and ordering a healthy salad or getting a Big Mac and substituting apple slices instead of french fries. Your other option is water; i.e. a 5-year treasury paying nothing.
- Co-written by Raheel Hirji