Investor Guide To U.S. Junk Bond ETFs

Eric Dutram: Despite the low rate environment, the bond market is seeing a great deal of popularity as of late. Yet although the broad sector is seeing significant inflows, many investors are zeroing in on the high yield segment instead thanks to their outsized yield and the relatively low default levels that these securities have seen over the past few years.

This combination has made them increasingly popular destinations for yield starved investors who don’t really want a huge upgrade in risk, but are willing to look beyond U.S. Treasury markets as well.

High Yield Bond Market

High yield bond ETFs invest in below investment grade securities (often called junk bonds), which are more volatile than the top rated ones with similar maturities. Investing in high yield bonds is a risky choice as these have a much higher default rates than Treasury bonds.

An outsized default rate can result in lower returns overall, although the higher yields do help to compensate for the added risks. Additionally, these bonds are vulnerable to economic downturns and can be hurt by a rising interest rate environment.

Currently, interest rates remain at a subdued level. As the Euro-zone continues to be a mess, U.S. recovery remains spotty and a worse-than-expected slowdown shrouds the emerging economies, the rates are unlikely to go up any time soon (Read: Is The Bear Market For Bond ETFs Finally Here?). Further, default rates would rise but at a modest pace and could remain below the long-term average of about 4%.

However, the current default rates seem to be lower when compared to historical levels for junk-rated securities. But yields in this sector still offer a significant premium over the more highly rated Treasury bonds.

Further, junk bonds tend to be more short-duration focused, suggesting that when rates eventually do rise, these securities are likely to be less impacted than their peers. All these situations call for an ideal condition for high yield bond investing in the short-term.

Rather than playing directly on the bond markets, investors can look towards bond ETFs as these often offer up a more diversified and lower risk choice in this uncertain market segment. In addition to greater flexibility in terms of trading and tax liabilities, ETFs provide investors better transparency while the basket approach helps to cut down on risk and volatility when compared to single bond investments.

Here, we look at the domestic high yield bond ETFs, which offer an attractive upside potential and strong returns. Given a low rate environment, strong bond fundamentals and an uncertain economic growth, yield-hungry investors find it difficult to ignore this opportunity to tap meaty dividends.

Peritus High Yield ETF (NYSEARCA:HYLD)

Investors seeking capital appreciation in addition to high yields may find AdvisorShares entrant in December 2010, an attractive play in the bond market. This is an actively managed fund with securities that offer the best value and least credit risk to investors in the high yield space.

The fund focuses on the junk corporate market, with the lower effective duration of roughly 3.46 years, higher average yield to maturity of 11.57% and a higher average coupon rate of 9.67% (Read: Are Investors Taking Another Look At Junk Bond ETFs?).

In terms of credit quality, HYLD focuses on low-investment grade bonds (B+ and lower) and holds about 40 securities. With AUM of $177 million, the product has an average bond maturity of five to ten years. It also invests in certain equities, which pay higher dividends or are otherwise consistent with the fund’s investment objective, to a lesser extent.

The ETF is widely diversified across sectors. Healthcare takes the top position in the basket followed by transportation and oil & gas.

The product has gained added a few percent in the past year and trades in volume of about 35,000 per day on average. It pays out a high annual dividend yield of about 8.93% per annum.

The 30-day SEC yield is greater at 9.1%. Nevertheless, the fund charges a fee of 1.36% per year, which looks expensive, and has a higher portfolio turnover ratio of 81% on average.

SPDR Barclays Capital High Yield Bond ETF (NYSEARCA:JNK)

For another option in the high yield bond ETF space, investors have the ultra-popular JNK, initiated in November 2007. With assets of $12.6 billion under its management, the fund tracks the overall performance of the Barclays Capital High Yield Very Liquid Index, which includes fixed-rate, taxable, low rated corporate bonds usually ‘BBB’ and below. The individual bond has more than $600 million in face value and remaining maturity of at least one year.

The fund is heavily exposed to the industrial sector and holds around 225 bonds in its basket (Read: Three Industrial ETFs Outperforming XLI). The product has a modified adjusted duration of 4.32 years and average yield to maturity of 7.60%.

JNK is one of the most liquid funds as it trades in heavy volume of more than 4.5 million shares a day. The fund delivered decent returns in the trailing one year period while its 30 day SEC yield comes in at 5.7%. It is a low cost choice in the high yield bond space, charging 40 bps in fees per year from investors.

iBoxx $ High Yield Corporate Bond Fund (NYSEARCA:HYG)

The fund, issued by iShares in April 2007, seeks to match the performance of the iBoxx $ Liquid High Yield Index, before fees and expenses. HYG is the largest bond ETF in the high yield bond space and holds 623 securities with heavy focus on short and intermediate term corporates.

About 70% of the product’s holdings mature in less than 10 years, giving HYG an effective duration of just 4.1 years and yield to maturity of 6.69%. In terms of credit quality, the fund focuses on higher quality non-investment grade bonds, allocating just 15% of the portfolio to bonds rated ‘B’ or lower. Instead, ‘BB’ bonds make up nearly 42% of the portfolio while ‘B’ rated securities comprise the rest. These lower rated bonds reduce the risk of higher defaults. Further, the fund has a solid yield with the average coupon of 5.7% (Read: Top Three High Yield Junk Bond ETFs).

From a sector look, consumer service makes up about 17% of the total, while financials and oil & gas sectors comprise another 12% each of the product. The product has so far attracted assets worth $16.4 billion and is the most popular and most liquid ETF in the bond space.

The fund charges fees of 50 bps from investors per year and trades in heavy volumes of 3.3 million shares, suggesting that it is a very liquid choice in the space.

PowerShares Fundamental High Yield Corporate Bond Portfolio (NYSEARCA:PHB)

Launched in November 2007, this ETF seeks to replicate the price and yield of the RAFI High Yield Bond Index, holding 220 securities. The fund holds U.S. bonds registered for sale in the U.S. that have at least one year until maturity and focus on B to BBB rated bonds.

The ETF weights securities by a combination of fundamental factors and puts about 13% of the assets in top 10 holdings (Read: Are The Fundamental Bond ETFs Better Fixed Income Picks?). With total assets of $887.3 million, the fund has a low effective duration of 4 years and targets only mid-term corporate bonds.

Consumer discretionary constitutes the top spot in the basket, followed by financials and energy. The product yields about 3.9% in 30 Day SEC terms, a reflection of its lower overall effective duration. It also looks cheap as it charges 50 bps from investors in fees per year. However, it is less liquid, which might increase the cost of investing in the form of a higher bid/ask spread.

Market Vectors High-Yield Muni ETF (NYSEARCA:HYD)

Investors seeking to target an array of municipal bonds from across the country may find Van Eck product an intriguing option. Being the nation’s first ETF to focus on high-yield munis, this ETF tracks the Barclays Capital Municipal Custom High Yield Composite Index and puts 75% in non-investment grade munis while allocating about 25% to Baa/BBB rated securities as well (Read: Looking For Income? Try High Yield Muni ETFs).

Launched in February 2009, the fund has so far attracted around $1 billion in assets and holds 259 securities in the basket. It allocates about 14% securities in top 10 holdings with heavy focus on industrial revenue and healthcare. These two sectors comprise the lion’s share (70%) of the assets in the basket.

Maturity of the munis is tilted towards the longer period giving the fund a greater focus on yield and interest rate risk. As a result, the average modified duration is higher at 10.82 years and yield to maturity is 6.22%.

Further, the product is widely spread out across various states as New York bonds comprise about 8.4% of the fund, while California bonds make up another 7%. Beyond these two, the rest of the top five is rounded out by the states of Illinois (6.9%), Texas (6.9%) and New Jersey (6.1%).

The fund is the low cost choice in the space with an expense ratio of 0.35%. Trading with volumes of about 300,000, the product has seen a solid double digit appreciation in the trailing 12 month period, while its 30 Day SEC yield comes in at roughly 4.5%.

SPDR Nuveen S&P High Yield Municipal Bond ETF (NYSEARCA:HYMB)

This ETF is the new entrant in the high yield munis bond space with AUM of $196 million. Launched in April 2011, the fund seeks to replicate the price and performance of the S&P Municipal Yield Index, before fees and expenses. Bonds in the fund include municipal bonds issued by the U.S. states and territories or local governments or agencies and should be exempt from federal taxes. (Read: The Forgotten Municipal Bond ETFs)

In terms of credit quality, the fund comprises BBB and lower rated munis bonds having longer maturities. With holdings of 122 securities, the product has yield to maturity of 5.90% and modified adjusted duration of 10.32 years.

It is also widely spread in the U.S., with California and Florida munis comprising 15% and 10%, respectively. The other top three bonds are from New York, Illinois, and Colorado and together these make up nearly 23% of the fund.

The product trades in lower volume and charges 45 bps in fees per year. However, the 30-day SEC yield of 4.0% and tax equivalent yield of 6.2% could make the fund attractive to yield hungry investors, especially if tax rates make these investments even more appealing.

0-5 Year High Yield Corporate Bond Index Fund (NYSEARCA:HYS)

This is the first ETF that provides exposure to the short-term high yield corporates and was initiated by PIMCO in June 2011. The fund seeks to match the performance of the BofA Merrill Lynch 0-5 Year US High Yield Constrained Index, holding 217 securities in the basket.

With lower effective duration of 1.7 years and an effective maturity of just 2.9 years, the product is less volatile than the broad maturity high yield counterparts. The fund has total assets of $725 million under its management. It is less liquid, as it exchanges only 70,000 shares per day.

The product has generated average returns for the trailing one year period, in line with many other products in the category. However, its 30-day SEC yield of 4.1% appeals to investors seeking current income, while it represents a reasonably priced choice in the space as it costs 55 basis points a year.

SPDR Barclays Capital Short Term High Yield Bond (NYSEARCA:SJNK)

Investors looking for short-term exposure to the high yield space may also look at the State Street’s entrant into the space. Launched in March 2012, this ETF seeks to match the price and performance of the Barclays Capital US High Yield 350mn Cash Pay 0-5 Yr 2% Capped Index, before fees and expenses.

With holdings of 275 securities in the basket, the fund consists of corporates having maturity of less than 5 years and has BB and lower rated bonds. This gives a lower average duration of 2.17 years and a 30-day SEC yield is 5.1%.

The fund has so far attracted about $550 million assets and trades in quantities of 230,000 shares per day. It generated modest returns since inception, while it costs just 40 basis points a year in fees.

Market Vectors Fallen Angel ETF (NYSEARCA:ANGL)

This innovative fund debuted in April 2012 in the high yield bond space. It seeks to replicate the performance of the BofA Merrill Lynch US Fallen Angel High Yield Index, holding 65 securities in total. The fund seems to be an interesting choice for investors as it focuses on ‘fallen angel’ bonds.

These bonds consist of securities that were once investment grade but have fallen from grace and are now trading as junk bonds.Bonds in the underlying index generally consist of BB and B rated corporates, which together make up for 91% of the asset base.

The index is weighted towards industrial bonds with 63% share, with the biggest allocations in this space going to telecom and basic industries (Read: U.S. Telecom ETFs: Opportunities and Threats). Financials and utilities make up for the remaining portion in the fund. It has good yield to maturity of 6.38% with modified duration of 5.48 years.

The ETF pays out a 30 Day SEC yield of about 5.7% while it charges a low expense ratio of 0.40% like many other ETFs in the space. It has delivered modest returns since inceptions, and could be a fresh way to target undervalued and overlooked bonds in the space.

iShares Baa-Ba Rated Corporate Bond Fund (NYSEARCA:QLTB)

Initiated in April 2012, this fund targets the U.S. corporate high yield bond market with securities of Baa1- Ba3. It seeks to match the performance of the Barclays Capital U.S. Corporate Baa – Ba Capped Index, holding 260 securities in the basket.

Since the fund does not have any limitation to maturity, its average maturity comes in at relatively high 10.03 years. Compared to many other funds in the space, QLTB has lower yield to maturity of 3.2% and higher effective duration of 6.6 years, which raises the interest rate risk.

With AUM of $10.1 million, the product puts more focus on the industrial sector with 67% share followed by financial institutions and utilities (Read: Utility ETFs: Slumping Sector In Rebounding Market). This fund is cheap, charging 30 bps in fees per year, but it has low volume and it has been a bit of an underperformer for most of 2012.

iShares B-Ca Rated Corporate Bond Fund (NYSEARCA:QLTC)

This fund, launched in April 2012, is similar to QLTB. It comprises B1–Ca rated securities with 126 holdings in total. The securities in the fund generally have maturities of 5-10 years, with average maturity of 4.5 years. With low effective duration of 3.8 years, the product has a relatively low interest rate risk compared to others on the list.

With AUM of about $10 million, the fund tracks the Barclays U.S. Corporate B-Ca Capped Index. It gained a bit since inception and yields a solid 6.4% in 30 Day SEC terms. However, when compared to QLTB, this fund is quite expensive as it charges 55 bps in fees per year.

Written By Eric Dutram From Zacks Investment Research 

In 1978, Len Zacks discovered the power of earnings estimates revisions to enable profitable investment decisions. Today, that discovery is still the heart of the Zacks Rank, a peerless stock rating system whose Strong Buy recommendation has an average return of 26% per year.

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