Lehman High Yield Bond ETF: JNK in the Trunk

Over the last several months, deteriorating economic conditions have lured investors away from riskier assets and into safe havens such as treasuries and money markets. Since the summer of 2007, spreads for high-yield bonds over treasuries have measurably widened, reaching 7.5 percentage points last week - the largest since 2001. With effective yields nearing 10%, the question arising is whether we are near a tipping point to jump into these high yielding instruments or will fears over future economic uncertainties prove too high for investors to make a risk commitment of this magnitude?

The determining factor for investors may be their view of default rates over the coming year. While some expect them to increase dramatically, default rates remained low throughout 2007 and are currently well below their historical average. Outside of debt issued by the banking industry (where obvious questions remain), corporate balance sheets are in relatively good shape. The expected default rate of 2.3 percent for 2008 is historically low (see chart below), but it will undoubtedly rise as concerns over a slowing economy and a possible recession persist. However, if we are heading into a recession (or are already in one), the default rate has not given a similar indication to past recessions over the last twenty years. The default rate during the 2001-2002 recession averaged 7.3 percent to 8.3 percent and the rate during the 1990-1991 recession averaged 8.7 percent to 10.5 percent. So, either we lack the warning signs of a looming recession or a sizeable rise in defaults rates is forthcoming.

[click charts to enlarge]

* Sources: JPMorgan, Moody’s Investors Service. Note 2007 and 2008 default rate is a JPMorgan forecast.

Investors poured out of equities in November and again this month, indiscriminately selling anything and everything they could get their hands on. The swift movement from risk to risk-free included the high-yield market as investors flocked to safety. This differs from many past flights to and from quality, which have seen the high-yield market serve as a stepping stone for investors’ risk appetite as they shift along the spectrum between higher-risk equities and lower-risk corporate bonds. It is our belief that going forward, investors will test their hand at the high-yield market before we see a major movement back into equity markets.

There have historically been two ways to take advantage of this approaching opportunity: either by purchasing high-yield bonds directly or by purchasing baskets of bonds through a mutual fund. The introduction of high-yield exchange-traded funds (ETFs) to the marketplace over the last year provides a third opportunity for investment, perhaps the most intriguing of them all.

The liquidity of ETFs which allows them to be bought and sold at will (unlike many mutual funds) is an intriguing option for active investors. Utilizing the right tools, it is now possible for investors to easily implement a tactical high-yield bond strategy.

While the Merrill Lynch High Yield Bond Index has a slightly negative return over the last twelve month period (see chart below), the index withstood two corrections of four percent. The index corrected from a 2007 high on May 31^st by five and one-half percent to a near-term low on July 27^th. Recovering from the July bottom, the index nearly reached the May 31^st high in mid-October before again correcting nearly four percent through mid-January.

This increased volatility provides trading opportunities for investors. If an investor twice exited the market as yields were resetting upward in June and again in October, their performance would have been measurably enhanced versus the comparable indexes. It is often argued that market timing is difficult to perfect, but the high-yield market tends to move a little more slowly than equity markets. While it is possible to miss absolute market bottoms and tops, it is also possible to measure movements off of near-term lows and highs and use this as a signal to enter and exit the market. Another thing to keep in mind is that while not invested, investments are able to earn returns through short-term (risk-free) money market funds.

* Source: Merrill Lynch (www.mlindex.ml.com)

Three ETFs currently trade which should be considered when deciding the best way to implement a tactical high-yield bond strategy. State Street’s SPDR Lehman High Yield Bond ETF (JNK), the most recently launched ETF, tracks the Lehman Brothers U.S. High Yield Very Liquid Index. The two competing ETFs available are the iShares iBOXX $ High Yield Corporate Bond (HYG) which tracks the iBOXX $ Liquid High Yield Index and PowerShares High Yield Corporate Bond (PHB) which tracks the Wachovia High Yield Bond Index.

We compared the Lehman index (State Street) to the iBoxx index (iShares), and our analysis favors State Street’s product (JNK). While 2007 returns were similar for both indexes, Lehman outperforms iBoxx by 157 basis points annually over the last three years. The out-performance is even more measured on a five-year basis, with Lehman outperforming by 373 basis points annually (SSgA Strategy & Research). The Lehman is a riskier investment, with a higher downside deviation over the last eight years, but we believe investors are amply rewarded for assuming this risk. The Lehman index is market-capitalization weighted and the iBoxx index is equal weighted. The differing methodology results in a higher current yield of 10.33% for the Lehman index versus a yield of 9.38% for the iBoxx index.

Only time will tell if the optimal moment to invest in high-yield bonds is now or if a slowing economy and rising defaults will lead to an even more attractive opportunity in the future. Nonetheless, we believe the prospect exists to invest in the high-yield bond market, and we recommend using JNK to add to the size of the nest-egg in your trunk.

Disclosure: At the date of publishing, Kenjol clients and/or employees do not currently maintain positions in JNK, HYG, or PHB.