David Fabian: High yield bonds, otherwise known as junk bonds, have been an excellent source of capital appreciation and income for several years now. They have benefited from the Fed’s ultra-low interest rate mandate, which has forced income seeking investors to broaden their horizons for risk assets. This in turn has prompted billions of dollars to flow into below investment grade credit quality holdings at a tremendous pace.
This risk taking mentality and low interest rate environment has allowed the junk bond market to bypass its normal cyclical nature to reach surprising new heights. Companies have also continued to take advantage of these ideal circumstances to refinance or issue new debt at excellent rates, despite their low credit scores. The bull market in stocks has also helped to prop up high yield credit which typically moves in a similar fashion to equities.
Frankly I don’t blame anyone for wanting to seek a higher return on their assets than the 2.07% yield that an aggregate bond portfolio such as the iShares Core Total U.S. Bond Market ETF (NYSEARCA:AGG) can provide. This type of low yielding investment becomes even harder to swallow when you consider the threat of rising interest rates can quickly wipe out any marginal income that this ETF manages to produce.
The biggest ETF in the high yield fixed-income space is the iShares High Yield Corporate Bond ETF (NYSEARCA:HYG), which has more than $13 billion under management. If you look at the 5-year annualized returns of this fund through 12/31/13, you would be amazed to see equity-like gains of 15.01% per year. In fact, HYG has continued to march even higher in 2014, which has pushed the 30-day SEC yield down to a relatively meager 4.49%. When you consider that the 12-month trailing yield is noted at 5.96%, you can see just how much less income new money would receive today than it would a year ago.
The last spat of volatility in HYG came back in mid-2013 when the Fed indicated a potential for tightening the reigns of quantitative easing and raising the Fed Funds rate. Many investors saw this as an opportunity to adjust the duration of their high yield bond holdings by moving to a shorter duration fund such as the PIMCO 0-5 Year High Yield Bond ETF (NYSEARCA:HYS).
This strategy provides a measure of security from the threat of rising interest rates and still captures a higher yield than an aggregate bond portfolio. Another popular alternative to reduce interest rate risk is the use of bank loan ETFs such as the PowerShares Senior Loan Portfolio (NYSEARCA:BKLN).
While I have been a big proponent of these moves in the past, I am hesitant to recommend that investors put new money into high yield fixed-income or bank loans at this time. The height of prices, compression of yields, and general complacency in the low credit quality arena has made me cautious about the risk to reward equation from this point forward.