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Future History of High Yield Bond Funds

|Includes: iShares iBoxx $ High Yield Corporate Bond ETF (HYG), JNK, PHB
The Future History of High Yield Bond Funds
While there are many high yield bond funds this report examines four from major fund families as proxy for the entire sector. Three of the four high yield bond funds began in 1989-1990 with the fourth starting in 1996. The Vanguard fund (MUTF:VWEHX) started in July 1989 followed by both TRowe Price (MUTF:PRHYX) and Fidelity (MUTF:FAGIX) in September 1990. The Janus fund (MUTF:JAHYX) didn’t start until June 1996. Nevertheless all four have followed a similar NAV path over the years. Which is somewhat unremarkable since each fund operates in the same high yield bond sector albeit with differing guidelines. As high yield ETF’s have entered the market three were also compared to TNX from their start in early 2007 through 2010. 
The period from 1989 to the present 2011 has been unprecedented in the length and breadth of the decline in overall interest rates. As typified by the 10 year Treasury Note, rates fell from 9.04% in April 1990 (end of month, basis TNX) to a low of 2.24% in December 2008. From that December low rates have rebounded to a level of 3.30% as of April 2011. What is most puzzling is that during this massive drop in interest rates the NAV of all of these funds has also declined which is the opposite one would expect. Normally if interest rates decline the value of a bond (and presumably a bond fund) would rise to produce a market equivalent yield. But that hasn’t happened. Indeed, as NAV’s decline the distribution rates for the funds also decline. Although it is likely that distribution rates lead NAV’s. Still, as interest rates generally declined, NAV and distribution rates also declined and did so in near lock step with interest rates. 
It wasn’t always so. Up to early 1998 the NAV of the bond funds moved opposite the interest rate. As rates rose the NAV declined. When interest rates declined the NAV rose. But as time wore on this relationship seemed to diminish until a point early in 1998 (generally March-April) when it disappeared altogether. Why? Not sure, but a possible culprit might be that the fund managers sought to maintain duration at the expense of both NAV and distribution. In so doing the managers churned the fund portfolios selling off higher yielding bonds in favor of lower yielding but longer duration bonds. The lack of significant capital gain distributions makes even this somewhat suspect however. Another possibility might be the expectation of the recession but that didn’t even start until July 1990! Was this breakdown an early warning sign? In any event the NAV and distributions of the funds continued to decline from early 1998 to mid 2002 (about July 2002) before beginning a recovery. 
The early stages of that recovery actually seemed to resurrect the old contrary, direct relationship as TNote (TNX) yields continued to decline until May 2003. Obviously this was the extended period during and after the 2000-2001 recession and 911 attack when interest rates were held artificially low. At some point in 2003 as the economic recovery was noticeably underway rates began to rise. Again, the generalized rise in NAV may have presaged the future economic gains. As the economic recovery was gaining steam three of the four fund NAV’s hit a peak and leveled out while the Fidelity fund continued to rise to an April 2007 peak. At that point all four funds began a sharp NAV decline before hitting a bottom in November 2008. (Note that intra-month lows were hit for several more months until about March 2009.) Once again the NAV decline presaged the 2008-2009 recession by nearly a year. The NAV decline was mirrored by a drop in TNote yields meaning that the expected inverse relationship had broken down once again. When NAV’s began to rise after the recession lows so did interest rates. A brief fall in interest rates from March 2010 to August 2010 was accompanied by a modest drop in NAV but when rates rose again, so did NAV. 
It is this contemporary, contrary, direct relationship of interest rates and fund NAV that is most puzzling. It would seem that it should be an inverse relationship yet seems more often than not to be a direct relationship. And curiously monthly NAV seem to presage large economic trends both up and down. What then does the near term future hold for these funds? 
Two major secular trends are the economic recovery and the potential for rising interest rates. Of the two the interest rate rise seems a bit less likely. The end of QE2 may in fact result in a drop or at least a flattening of current rates. Lower interest rates was the ostensible outcome of the end of QE1 which then raised deflation fears and gave birth to QE2. Unlike then the current economic recovery seems stable if less than robust. Even the prospect of a gradual rise in interest rates should not disrupt this recovery. It is possible that the end of QE2 may produce a stronger dollar, lower commodity prices and lessened inflation fears. This would be impetus for a stronger recovery balanced somewhat by Fed fears of deflation. Such a recovery suggests a further rise in the NAV of the high yield bond funds. Perhaps the NAV rise seen so far presages good economic news and bodes well for profitable investments in the high yield bond sector. 
Chart of high yield bond fund NAV versus 10 year TNote 
High Yield NAV vs TNX
A pattern similar to the TNX and high yield funds exists between TNX and the share prices of three high yield ETF funds: PHB (PowerShares Fundamental High Yield Corporate Bond Fund), JNK (SPDR Lehman High Yield Bond), and HYG (iShares iBoxx$ High Yield Corp Bond). 
Chart of high yield ETF share prices versus 10 year TNote 

As interest rates (TNX) declined from mid 2007 through the end of 2008 all share prices also declined. As rates rose from the 2008 lows share prices rose as well. This contrary, direct relationship reversed early in 2010 though as a more normal inverse relationship appeared. As rates generally declined or were relatively stable share prices generally rose.
Long EVV