Assembling Your High-Yield Bond ETF Game Plan

yieldMichael Fabian: While the equity market is continuing to show the initial signs of cracking under the pressure of recent economic data, high yield bond investors have already gone for a bit of a ride. Spreads are gyrating all over the place, and if you have lightened up on your high yield bond exposure over the last few months in anticipation of a better entry point as spreads inevitably widen; you should be paying very close attention to what happens next. Planning your future portfolio management decisions now will play a key role in reestablishing positions you may have let go of, or never owned in the first place. Over the weekend I was performing some comparison analysis of an ETF we had recently sold for clients in our strategic income portfolio, and two other popular fixed income ETFs. In doing so, I came a few interesting conclusions that have reinforced my future purchase decisions, in addition to solidifying my target price-levels.

In the chart below, I have compiled a 9 month total return comparison of three high yield fixed income ETFs, the iShares High Yield Corporate Bond ETF (NYSEARCA:HYG), the SPDR High Yield Bond ETF (NYSEARCA:JNK), and the PIMCO 0-5 Yr High Yield Corporate Bond ETF (NYSEARCA:HYS).

As readers may recall, I’ve been a big proponent of the PIMCO ETF for my clients portfolios due to its superior index construction and low sensitivity to interest rates. I don’t believe HYG or JNK offer much opportunity for investors to increase their alpha in comparison to other ETF products or actively-managed mutual funds. However, the most interesting observation I gathered from this simple comparison is the overall similarity in the recent performance of the three.

Even in April, when high yield bonds were performing well due to strong risk asset performance in addition to falling interest rates, HYS held its own vs the other two long duration counterparts. To put this divergence plainly, HYG and JNK have effective durations of approximately 4 years, while HYS has an effective duration of just under half that at 1.94 years. An investor willing to take twice the amount of interest rate risk should expect the added benefit in bottom line performance in a falling rate environment. Furthermore, when analyzing the most recent correction in all three funds, in light of the rise in treasury rates and the volatility in risk assets, HYS is still outperforming. This should be evidence enough to support moving down the curve to HYS once a buying opportunity presents itself.

So how will you know when to buy?

As shown in the chart below, the low in spreads coincided with interest rates bottoming in late April/early May. One could assume that in a typical market environment, if risk assets stay strong and there is a rotation out of quality fixed-income, spreads could continue to compress. However, more recently fixed-income investors have been hit with both quality and credit security price underperformance. So even though spreads may not be widening to the extent they did back in late 2012, be mindful that high yield bond prices are becoming more attractive.

High yield investors should keep in mind that when examining a spread, they are viewing the difference between U.S. treasury rates and high yield bond rates, so one must also examine each index independently to ascertain the entirety of the investment thesis. As I discussed in my recent article, Evaluating Your Sensitivity To Market Changes, if we are able to hold the top end of the channel in treasury rates, and potentially continue to see risk assets underperform, a great buying opportunity could be setting up in high yield bonds.

Obviously it would be preferable to see spreads reach as high as 6%, a technically significant resistance level. However in light of treasury rates climbing in concert with high yield rates, we may only see spreads reach approximately 5-5.5% before stabilizing. It truly depends on the level of risk aversion in the market place.

Now is the time when you need to be monitoring high yield bond ETFs closely so that an allocation opportunity doesn’t pass you by. The strategy we are implementing for our clients will include making purchases in HYS, or a similar actively-managed strategy such as the Osterweis Strategic Income Fund (OSTIX), once spreads reach more attractive levels coupled with a stabilization in the 10-year treasury rate. Although these conditions might not materialize for some time, developing a plan, then monitoring the indicators, will keep our capital safe until value reemerges in this sector.

This article is brought to you courtesy of Michael Fabian from Fabian Capital Management.

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