The quarter ended on a positive note for junk bonds. As the market rebounded from the sharp June sell-off, investors started to turn back to high yield from essentially zero-yield Treasury bonds -- and, of course, Friday's announcement of positive news from the EU summit spurred a broad market rally.
Nonetheless, there's still time to buy junk. A look at TLT charts and the 30-year Treasury yield shows that government bond yields are at their lowest level since right after the financial crisis crash:
click to enlarge
As I've established before, the future is bleak for Treasury bonds. With yields actually negative after accounting for inflation and taxes, you can be sure that investors will flock to higher-yielding instruments like equities and riskier bonds on the hint of good news. If the market reacts the same way to the recent EU summit conclusion as it did back in October, the next few months could be very pretty for risk-on assets -- and very ugly for "safer" T-bonds.
Junk's recent underperformance is fairly characteristic of times of economic uncertainty. Over the long term, of course, junk bonds typically provide better returns than Treasuries, even when adjusted for risk. Right now is one of the best times to buy junk bonds, because of the "terror" discount that's built into the price. As explained by John Waggoner for USA Today:
These are perilous times, and investors are willing to pay a premium for safety. Long-term government bond funds have trounced junk and corporate bond funds, rising an average 9% a year.
Why have junk funds lagged? In a word, terror.
Of course, in the longer-term, investors will much prefer riskier assets that provide higher yields. "Safe" bonds have run their course and provided investors with good returns, but it's time to realize that the low yields don't justify further investor interest. Long-term government bonds are priced for doom right now, and it's best to sell and get out. If you're not confident of the market, keep your money in cash -- but if you're willing to take on a bit more risk, I'd advise following the strategy of Wells Fargo's chief fixed-income strategist Jim Kochan:
Treasury yields are too low to warrant any investor interest, as are yields on just about anything closely associated with Treasuries. Kochan notes that high-yield spreads are still very wide, even though much of that is due to how extraordinarily low Treasury yields are. But those high spreads and yields currently just south of 8% mean junk bonds can withstand any backup in Treasury yields we might see, and for the next 12 months Kochan thinks investors can expect to receive coupon income with limited default risk. "We're in the sweet spot of the credit cycle," he says.
Investment Options
Holding individual bonds can subject an investor to significant concentration risk, so for most retail investors who don't have extremely large portfolios and the time/ability to pick individual bonds, I prefer a diversified ETF or fund. Any of the ETFs mentioned below would serve as a good starting point, as would a high-yield mutual fund -- check with your broker for available funds.
High Yield ETFs
- Peritus High Yield ETF (HYLD) - Actively managed ETF
- iShares iBoxx High Yield Corporate Bond (HYG)
- SPDR Barclays Capital High Yield Bond (JNK)
- PowerShares Fundamental High Yield Corporate Bond (PHB)
Disclaimer: I am an individual investor, not a licensed investment advisor or broker dealer. Investors are cautioned to perform their own due diligence. All information contained within this report is presented as-is and has been derived from public sources & management. Always contact a financial professional before making any major financial decisions. All investments have an inherent degree of risk. The future is uncertain, and actual results may be materially different from those expected. Past performance is no guarantee of future results. All views expressed herein are my own, and cannot be interpreted as the views of my employer(s) or any organizations I am affiliated with. Presentation of information does not necessarily constitute a recommendation to buy or sell. Never make any investment without conducting your own research and reading multiple points of view.
Additional disclosure: I am long the Fidelity Capital and Income Fund (FAGIX).
