Junk Bond ETFs: Too Good To Be True?

by on June 18, 2010 | ETFs Mentioned:

Investors who have taken measures to protect their portfolios against the ravages of inflation will have to continue to hold their breath; the last week saw the release of two reports indicating that an uptick in prices is still a long ways off. The producer price index (PPI) fell by 0.3% in May, the third decline in four months. Separately, the more closely-followed consumer price index (CPI) also dipped last month, putting the measure of prices paid by consumers slightly below its January level.

Different investors have interpreted these developments in different ways. The weakness in prices is likely an indication that the economic recovery remains fragile. But it also means that the Federal Reserve is not feeling any pressure to hike interest rates in the short term; some are predicting that rates could remain near record lows until at least 2012. That maybe good news for equity markets, but it likely signals an extension of a period that has seen key interest rates hover near zero and fixed income yields plummet.

For investors who had grown accustomed to juicy yields from the bonds allocation of their portfolios, the last two years have seen the dawn of a challenging environment, as yields on Treasuries have sunk and returns from money market accounts have virtually disappeared. Finding an attractive yield among the universe of fixed income ETFs is a tall task. The 30-Day SEC yield on the iShares Barclays Capital U.S. Aggregate Bond Fund (AGG), a popular core bond ETF offering exposure to the investment grade universe, is just 1.7%; the yield to maturity is well under 3%. The yields on many of the ETFs in the Government Bonds ETFdb Category are even lower.

But for investors looking to generate a more attractive current return, there are a number of interesting options, especially for those willing to take on slightly more risk and venture into junk territory:

  • iBoxx $ High Yield Corporate Bond Fund (HYG): This iShares ETF offers a 30-day SEC yield just north of 9%, with an approximately equivalent distribution yield.
  • SPDR Barclays Capital High Yield Bond ETF (JNK): State Street’s junk bond ETF has a 30-day SEC yield of about 9.5% and an average coupon of nearly 9.3%.
  • PowerShares High Yield Corporate Bond Fund (PHB): This ETF, the smallest in the High Yield Bond ETFdb Category, has a 30-day SEC yield of 8.9% and a weighted average coupon well north of 8%.
  • Market Vectors High Yield Municipal Index ETF (HYD): The index underlying this ETF has a 25% weighting in BBB municipal bonds and a 75% weighting in non-investment grade municipal bonds. Currently, HYD has a 30-day SEC yield of about 5.9%, which translates into about 9% for those in the 35% tax bracket (municipal bonds are generally exempt from federal taxes).

The juicy yields on these funds may seem too good to be true, but it’s important to keep in mind that the underlying holdings have been nicknamed “junk” bonds for a reason. A look at JNK’s holdings, for example, uncovers debt issued by a number of companies facing challenging operating environments. Major holdings include cash-strapped casino operator Harrah’s, struggling alternative energy provider Wind Acquisition Finance SA. Many of the companies that have issued debt held by these ETFs are highly leveraged, and their ability to make good on their obligations is far from certain.

A look at the credit quality breakdowns of these ETFs (HYG; JNK; PHB; HYD) helps to explain why the yields offered are in the stratosphere; most invest exclusively in debt rated BB or lower, a grade used to reflect significant concerns about the cash flows and ability to repay loans of the issuing firm.

It’s also worth noting that junk bonds generally don’t provide the same diversification benefits that make investment grade fixed income components a vital portfolio holding; since its inception JNK has exhibited a correlation coefficient with SPY of about 0.50, while the correlation between SPY and AGG is slightly negative.

For yield-hungry investors with the stomach for a bit of volatility, junk bond ETFs can be an efficient way to juice a portfolio’s current return. But, as always, these attractive yields come with commensurate risk (see Seven ETFs For Investors Mourning The Death Of BP’s Dividend).

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Disclosure: No positions at time of writing.