Junk Bonds vs. Treasuries: Is it Time?

 |  Includes: CIU, HYG, IEI
by: Keith Lenger

It looks like the junk bond market is finally starting to move. We have not held a position in our portfolios for a very long time.

Is it time to buy? Well, in Tuesday's WSJ article: “The Junkyard Dogs Investors In Some Funds: Rising Risk Premiums Hit High Yield Holdings; ’I Wouldn’t Be an Owner'”, we were left with the impression to shy away. Of course, this follows on the heels of Monday's article: “After Junk Bond Swoon, Is It Time to Buy — or Wait; Jumping in May Yield Big Rewards, but Mess at Bear Deepens Fears.“, where we were left with a rather favorable impression.

It should be noted that each article was written by a different author. After reading both we are reminded that it takes two sides to make a market. Furthermore, it highlights the need for the average independent investor to take the time and assimilate the loads of information and opinion before investing.

We took a look at (NYSEARCA:HYG), a high yield ETF, with a 30-day sec yield of 7.45%, effective duration of 4.88 and weighted avg maturity of 6.80 years. We did a quick run through the various ETF list and think this might be the only High Yield ETF offering (we could be wrong here).

Typically, most professionals will take a look at the spreads between junk and treasuries. However, for the independent investor wishing to gain exposure this may not be the best way to go, since it only gives a proxy. Rather, we would suggest trying to compare products that are easily available and that you will be using. To keep it simple we stayed in the iShares family and compared against (NYSEARCA:IEI) and (NYSEARCA:CIU), the Lehman 3-7 year Treasury Bond Fund and the Lehman Intermediate Credit Bond Fund. IEI has a 30-day sec yield of 4.94%, effective duration of 3.91 and weighted avg maturity of 4.44 yrs. CIU has a 30-day sec yield of 5.54%, effective duration of 4.20 and weighted avg maturity of 5.12 yrs.

Before we move on, let's quickly review the definition of effective duration and the various duration forms (click here- a bit analytical). As we compare, moving from treasuries to high yield, the risk characteristics increase. In this particular case, we are looking at high yield for our max growth portfolio. Given that these portfolios have a long investment horizon and can weather volatility, we are not going to add the treasury fund.

However, lets take a look at the interest spread between the treasury fund and high yield, 4.94% and 7.45% respectively. Is 2.5% enough compensation to take on the risk? Additionally, the effective duration is relatively narrow with a difference of .97. We thought it would have been greater. If you compare to corporates, the variables are even more compressed. We have used these funds in order to give a proxy of the risk trade-off within the different asset classes. We would like to see further compensation in yield before moving into this asset class. On the same note, we are a bit struck by how close the risk parameters are in the different investment vehicles.

Here is one of the major flaws with our quick armchair analysis: It does not compare high yield to other asset classes, like equities, which high yield funds are often compared to. Also, we did not really look into the total return or more specifically the potential for price appreciation. Given the narrow analysis, we are not convinced it is time to jump into the high yield class.

However, if the correction continues a bit further, we think it will be prime time to start allocating funds to this asset class. It is our opinion that risk premiums will continue to build, given poor investor turnout, additional hedge fund blow-ups and continued recent volatility in credit markets. Having said that, the asset class is firmly in our sites. We are just waiting to pull the trigger.