How To Play The Sweet Spot In High Yield Bonds

yieldDavid Fabian: I am an avid surfer and have always enjoyed being in the ocean throughout my life.  When I’m riding waves I find that it completely takes me away from the stresses of the financial markets and other daily tasks.  The key to successfully navigating the 10 second rush of adrenaline you get when you catch a swell is to find the sweet spot in the break.  That unique place that is not too far out on the shoulder and not too far back near the white water that will carry you the farthest and give you the smoothest ride.  With the ocean constantly swirling around you and currents threatening to push you off course, being in perfect trim will allow you to sail through the surf and emerge from the water unscathed.

I think that this concept can also be applied to fixed-income investing at the moment.  This year has been tumultuous for investors in long-dated treasuries, emerging market, and municipal bonds.  The stratospheric rise in interest rates has caught the vast majority of bond investors off guard and introduced a great deal of volatility back into what has traditionally been an asset class with minimal price fluctuations.  The exodus of income investors from bond ETFs and mutual funds has been well publicized amid concerns over higher interest rates and Federal Reserve asset purchase tapering.

However, there is still one slice of the bond market that is continuing to thrive amid the turbulent seas.  Short-term high yield bonds have been one of the best performing sectors in 2013 and have experienced very little price volatility.  Two ETFs that hold the majority of the assets in this space are the PIMCO 0-5 Year High Yield Bond ETF (HYS) and the SPDR Barclays Short Term High Yield Bond ETF (SJNK).

Both of these funds are currently sitting very near their all-time highs and have had excellent relative performance vs. their longer dated peers.  HYS has an effective duration of just 2.04 years and a current distribution yield of 4.33%, while SJNK has a slightly higher effective duration of 2.30 years and a 4.57% yield.  These ETFs have both benefited from their shorter durations which insulate them from the pernicious effects of rising interest rates.  In addition, their above-average yields make them attractive for income seeking investors that desire a steady monthly dividend stream from their holdings.

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