There's Still Time To Buy Junk

Includes: HYG, HYLD, JNK, PHB
by: Skyler Greene

Junk bonds are in an attractive place right now. Since my last article Want Income? Get High Yield, yield spreads over comparable Treasury bonds have tightened some. Investors are starting to catch on:

High-yield mutual funds and exchange-traded funds recorded a net inflow of $1.2 billion in the week ended Wednesday, according to Thomson Reuters-owned Lipper, almost double the inflow of the previous week that had followed four straight weeks of outflows.

The latest cash injection, which matched a $1.2 billion inflow for week ended May 2, brought flows over the past four weeks to minus $386.6 million, a dramatic improvement on the four-week average from the prior week of minus $1.3 billion.

Still Time To Buy

The "fear premium" in the yield spread is still quite high because of the European mess. However, this is purely based on fear - not rational analysis. The financial crisis cleaned out the cupboard, so to speak - bad companies defaulted, leaving only the good ones remaining. Now, high yield bond default rates are well below the historical norm. Yet due to weak economic conditions, investors are pricing high yield bonds like they're ready to default any second.

This provides a great buying opportunity for investors, as established in a thorough analysis by Oakshire Financial. While the yield spread over Treasuries was 723 basis points on June 5, it's dropped to 654. However, this still presents a bargain: the historical yield spread is 525 basis points. This level was seen in 2011, but after the US credit downgrade and Euro-panic, the spread has jumped.

Investors can still cash in on this spread: in the short term, it means high levels of income that can be reinvested like dividends. In the long term, it means price appreciation on any bonds held as yield spreads revert lower to the norm (and consequently, prices revert higher).

Junk bonds' coupon payments can help diversify a portfolio and protect against risk taken on by excessive equity holdings. In fact, Doug Peebles of AllianceBernstein recommends a 25/75 split between high-yield bonds and stocks, because this allocation optimizes risk-adjusted returns over the long term:

... 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.

Since high-yield's correlation to equities is low, an allocation to high-yield bonds can significantly improve the risk and return characteristics of an equity portfolio. Their low correlation to other types of bonds means that an allocation to high yield can significantly improve the efficiency of a diversified stock/bond portfolio, as well.

With Treasuries' yields below CDs, there's really not a lot of room in the fixed income market for yield right now. As I've established previously, Treasuries are in a bubble that's unsustainable in the long term. Given that Treasuries are overpriced - and high yield bonds are underpriced - investors might be wise to reallocate some T-bond holdings to high yield bonds.

Investment Options

Holding individual bonds can subject an investor to significant concentration risk, so I prefer a diversified ETF or fund. Other good options include mutual funds - I personally have a position in the Fidelity Capital and Income Fund (MUTF:FAGIX). Any of the ETFs mentioned below would serve as a good starting point, as would the Fidelity fund and the other mutual funds mentioned in the Zacks report I linked to. The fourth ETF on my list is actively managed.

  • iShares iBoxx High Yield Corporate Bond (NYSEARCA:HYG)
  • SPDR Barclays Capital High Yield Bond (NYSEARCA:JNK)
  • PowerShares Fundamental High Yield Corporate Bond (NYSE:PHB)
  • Peritus High Yield ETF (NYSEARCA:HYLD) - Actively managed ETF

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 the Fidelity Capital and Income Fund.

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.