Want Income? Get High (Yield Bonds)

Includes: HYG, JNK, PHB
by: Skyler Greene

I hate Treasuries. I've established before why they're about to collapse -- to recap, negative real yields are unsustainable.

Since I'm bullish on U.S. stocks, I think solid dividend-yielding blue chip stocks can provide high levels of both return and income in the coming years.

However, a 100% domestic stock allocation does not a wise portfolio make. In addition to emergency cash holdings, I'm partial to an often overlooked class of investments: high-yield bonds.

The Fundamental Case For High-Yield Bonds

While many investors view high-yield bonds as the riskiest component of the bond category, in truth, they should really be thought of as a category all to themselves. As explained by Doug Peebles, the Chief Investment Officer of AllianceBernstein Fixed Income, high-yield bonds really don't have a whole lot of correlation with overall bond returns:

The performance of high-yield bonds traditionally has not followed other fixed-income sectors very closely. Looking back over three decades, the correlation of high-yield bonds with investment-grade bonds has been just 0.30. With US stocks, the correlation has been 0.56... For these reasons, high yield, unlike other fixed income sectors, is typically insensitive to movements in interest rates. In fact, US high-yield bonds have a correlation of just 0.04 with 5-year US Treasuries over the long term.

As the name implies, high-yield bonds come with higher yields than stocks -- but as bonds, they have far lower volatility and risk than equities. Mr. Peebles goes on to say:

High-yield assets have delivered annualized returns only marginally below those of equities, with almost half as much volatility, over the past three decades. Yet high-yield bonds are less risky than equities, in that bondholders get paid before shareholders in bankruptcies.

High-Yield Bonds: Available at Attractive Prices

It's not news that investors have been piling into Treasuries as a consequence of fear out of Europe. The spike in Treasury prices and free falling yields add up to a bad bond buying picture: investors can get better interest rates on short-term CDs.

While Treasuries are drastically overpriced, high-yield bonds are actually underpriced. Why? Investors are worried about defaults. But according to Tom O'Reilly, portfolio manager of Neuberger Berman High Income Bond, they shouldn't be.

The default rate peaked in 2009 when 10% of junk bonds collapsed. Now most of the shakiest bonds have been eliminated. The survivors have been strengthening their balance sheets and refinancing debt. The ratings agencies have been upgrading many issues.

With the economy improving last year, only 1.8% of junk bonds defaulted, a rate that is below historical averages... despite the healthy performance, investors are pricing bonds as if they will suffer a default rate of 6%.

O'reilly projects a total return of 8-12% for high yield bond funds on the year, most of which comes from the 6-8% coupon yield. With Treasury yields stuck around zero for the foreseeable future, this is extremely attractive.

Best High-Yield Bond Opportunities

There are several ways to invest in high-yield bonds. Long-term investors can check out this article for a list of highly ranked high-yield bond mutual funds. There are also several ETFs tracking high yield bond performance, including:

  • iShares iBoxx High Yield Corporate Bond (HYG)
  • SPDR Barclays Capital High Yield Bond (JNK)
  • PowerShares Fundamental High Yield Corporate Bond (PHB)

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: I am long high yield bonds via the Fidelity Capital and Income mutual fund (MUTF:FAGIX).