Lay Off The High-Yield Bonds For Now

Includes: BBY, HYG, JNK, LQD, PHB, TLT
by: The Financial Lexicon

Stocks aren't the only things that have been on fire since early October. Non-investment grade bonds, also known as high-yield or junk bonds, have likewise been performing strongly. Despite the fact that, depending on which part of the Treasury curve you are focusing, benchmark Treasury prices (NYSEARCA:TLT) are either down or flat since the stock market October lows, high-yield debt prices, as a collective whole, are up significantly. Three high-yield exchange-traded funds, HYG, JNK, and PHB, are up 17.88%, 17.16%, and 10.76% respectively, excluding distributions, since their October lows.

The large price appreciation seen in these three ETFs is due to the spreads between high-yield debt and benchmark Treasuries contracting. Despite the fact that yields have risen on some parts of the Treasury curve since the October lows, high-yield spreads have managed to contract at rates far faster than Treasury yields rose, thereby helping to boost prices for high-yield bonds. At the moment, all three high-yield ETFs are sitting at or close to their highs reached since the March 2009 lows.

It is true that in recent weeks investment flows into high-yield funds have been quite strong. However, as an investor in individual bonds and someone who regularly searches the bond market for great investments from a risk/reward profile, I would like to note the difficulty I am having in recent days finding high-yield or investment grade bonds for that matter with what I consider adequate risk/reward profiles. Without a doubt, there are always a few hidden gems that an investor can find, but if you are investing in ETFs or other high-yield funds, you should be more concerned with the state of the market as a whole.

If you are a trader of the corporate bond ETFs, this seems like a good time to remain on the sidelines. Given that the ETFs are sitting at or near their highs since March 2009, that there has been a massive rally since the October 2011 lows, and the difficulty I am having in finding large numbers of what I would consider "good deals" in corporate bonds (I recognize some investors might differ with my opinion), a "wait and see" approach seems prudent. As a trader in corporate debt, I would do literally nothing at these levels.

If you are a longer-term investor in the exchange-traded corporate bond funds, exercising caution at these levels is worth considering. I recognize that longer-term investors often average into larger positions. Given the state of the high-yield market today, if I were building a position in any of the aforementioned high-yield ETFs, I would be scaling in with less vigor. If, for instance, you usually break a position up into thirds, perhaps change that to fifths, buying smaller positions today and waiting to see which way the market breaks.

For those investors favoring individual bonds, your comfort level with buying bonds trading at a premium to par or buying bonds in the lower reaches of high-yield will likely determine whether you will be purchasing any corporate bonds any time soon. Of course, there are exceptions, as some higher-rated bonds are trading as if they were lower rated (not in line with bonds of similar ratings and terms). One example from the investment grade space is Best Buy's (NYSE:BBY) senior unsecured, Baa2/BBB- rated note (CUSIP: 086516AL5), maturing 3/15/2021 with a 5.50% coupon and currently asking 97.572 cents on the dollar (5.849% yield-to-maturity).

On a closing note, when it comes to investing in high-yield bonds, here are a few things to keep in mind:

First, among junk bonds, spreads to benchmark Treasuries often move quickly and sometimes ferociously in reaction to changes in perceptions about the strength of the U.S. or worldwide economy. This has happened since the October lows to the benefit of high-yield bonds (spread contraction). Spread contraction, as well as spread expansion, can cause high-yield debt to become more correlated to the stock market, in terms of direction, than it is to other parts of the bond market (such as Treasuries or investment grade debt).

Second, when compared to other markets, high-yield is much more illiquid. This can further add to larger price swings. Investment grade bonds as a collective whole, for example, will often trade two times or more the dollar volume than the high-yield market on any given day. You won't notice this discrepancy in liquidity if you're just focusing on the volume of shares traded in popular ETFs. For instance, the popular investment grade corporate bond fund, LQD, has averaged roughly 1.573 million shares per day over the past 90 days. This compares to 2.5 million per day for HYG and 4.9 million per day for JNK over the same time period.

Last, keep in mind that the ETFs mentioned in this article are funds that do not mature at par. If you plan to sell the security at some point in the future, it is important to understand that your investment will fluctuate and will not trend towards par, as an investment in an individual bond would. This is because the funds have no maturity date. If you are interested in a bond fund designed to represent the performance of a held-to-maturity portfolio, Guggenheim's BulletShares corporate bond ETFs are worth exploring.

Good luck on your quest to find yield in this zero-interest-rate environment.

Disclosure: I am long BBY's CUSIP 086516AL5.