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When constructing the fixed income component of portfolios, most individual investors and financial advisors focus primarily on debt issued by the U.S. government and high quality corporate debt. But the fixed income universe goes far beyond Treasuries and investment grade corporate bonds. Many investors have embraced junk bonds as quasi-hybrid investment, a bridge between equities and lower risk fixed income securities.
Junk bonds, also known as high yield bonds or speculative grade bonds, refer to debt issued by corporations that is rated below investment grade by major ratings agencies (i.e., S&P, Moody’s, and Fitch). Debt is given a speculative rating if there is deemed to be a higher risk of default or other negative credit events. In order to make these debt issues attractive to investors, junk bonds generally pay a higher yield than investment grade bonds.
Junk bonds tend to have a relatively high correlation with equities, and are less dependent upon changes in interest rates than investment grade and risk-free debt. The recent recession is a good example of why this may be the case: as interest rates were slashed to stimulate economic growth, yields on investment grade bonds became more appealing, and prices rose. The economic downturn, however, increased the likelihood of default from companies that were not on solid financial ground (i.e., issuers of junk bonds).
Last month, Standard & Poor’s slashed its forecast for U.S. junk bond default rates to 6.9% for next year, less than a month after predicting defaults would increase to 13.9% by August 2010. A reopening of the bond markets following last year’s credit crisis is making it easier for risky companies to stay afloat. In September, S&P indicated that default rates could reach 18% if economic conditions worsened.
Despite the more upbeat outlook, yields on junk bonds remain very attractive, flirting with the 10% level in some cases. With rates on Treasuries lingering at or near record lows, many investors have turned to junk bond ETFs to enhance the returns on their fixed income investments. Despite these juicy yields, some believe a junk bond bubble is forming, with investors accepting less and less return to take on still significant risks.
Junk Bond ETF Options
There are several options for investors looking to invest in junk bonds through ETFs. While these funds offer similar exposure, they feature slightly different coupon rates, credit qualities, and expense ratios. ETFdb Pro members can learn more in our High Yield Bonds ETFdb Category Report (if you’re not a Pro member yet, sign up for a free trial or read more here).
iShares iBoxx $ High Yield Corporate Bond Fund (HYG): This ETF invests in more than 250 debt issues across several different industries, with no more than 10% exposure to a single sector. Nearly three quarters of underlying holdings of this ETF have a maturity date of five to ten years.
SPDR Barclays High Yield Bond ETF (JNK): This State Street ETF, which embraces the “junk bond” nickname given to high yield debt, invests in about 150 individual securities. Similar to HYG, maturities of this debt is clustered between five and ten years, although there is a moderate allocation to debt maturing in more than 20 years.
PowerShares High Yield Corporate Bond Portfolio (PHB): This ETF has a slightly better average credit quality than the other two ETFs highlighted above, resulting in a slightly less attractive 30 day SEC yield.
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