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Is it Time to Put Junk inside your Portfolio?

Is it Time to Put Junk inside your Portfolio?

By Ron DeLegge, Editor

May 5, 2008


SAN DIEGO ( High yield bonds, also known as junk bonds are on a roll.


Over the past month, junk debt has enjoyed its best month in years.


Nevertheless, three exchange-traded funds (ETFs) that track junk bond indexes are all posting negative year-to-date performance.


Through the end of April, the SPDR Lehman High Yield Bond ETF (Ticker: JNK) was off by 3.8 percent, the iShares iBoxx $ High Yield Corporate Bond ETF (Ticker: HYG) was down by 1.4 percent and the PowerShares High Yield Corporate Bond Fund (Ticker: PHB) was behind 3.8 percent.


PHB follows the Wachovia High Yield Bond Index, which chooses bonds using selected screens and then weights them equally. By equal weighting bonds, it prevents large borrowers from unduly influencing an index.


HYG follows an iBoxx index that selects bonds passively and then weights them equally.


Lastly, JNK’s underlying index selects bonds passively and weights them by market capitalization. The latter approach favors bonds inside the index with the greatest principal outstanding.


JNK has already attracted $349 million after just five months of trading.


Tom Anderson, Head of the Strategy and Research Group at State Street Global Advisors attributes strong asset flows into JNK from financial advisors and investors seeking diversified, cost effective exposure to high yield bonds.


"High yield bonds are an asset class with low correlation to many other segements of the

fixed income market, as well as equities," says Anderson.


He adds, "The recent flight to quality in the bond market has caused spreads - the difference between yields on high yield bonds and U.S. Treasury bonds - to widen signficantly, making them more attractive on a relative basis."


Investors typically gravitate to junk bonds for their high yields.


For example, JNK has a 30-day yield of 9.52 percent, which is 3.84 percent yield premium compared to investment grade corporate bonds (Ticker: LQD).


In operation, junk bonds are similar to other species of bonds. A corporation or another entity agrees to pay you interest (coupon) on lent money (borrowed principal) by a certain maturity date.


Junk bonds are characterized as “junk” because the companies issuing them have lower credit quality. Generally, bonds of established companies with strong financials are considered higher quality debt whereas bonds of companies with weak financials are higher risk investments. Because of their higher risk, junk bonds tend to have higher yields.


Rating agencies like Moody’s and Standard & Poor’s assign risk grades to bond investments. For example, Moody’s judges junk debt as anything with a rating lower than Ba or B. Similarly, Standard & Poor’s gives junk bonds a rating of anything lower than BB or B.   


What explains the recent runup in junk bond prices?


One factor could be the Federal Reserve’s decision to permit brokerage firms to borrow from the central bank. Some argue this move has given a positive boost to sentiment in the overall bond market.


Another reason could be investors are betting that the price of lower credit quality debt is close to bottoming.

In the future, one of the big risks facing junk bond investors is the possibility of accelerating default rates. According to Moody’s, bond defaults could hit 10 percent if the U.S. economy dips into severe recession.

Predicting the exact timing of defaults is an inexact science, but it’s a trend that merits attention. Investors need to judge for themselves the risk premium they need to earn to weather any potential storms.


Junk bond ETFs can be bought and sold during normal market hours, similar to stock ETFs.


Compared to junk bond mutual funds, corresponding ETFs have lower operating costs. Junk bond ETFs charge annual expense ratios that range from 0.40 to 0.50 percent versus the 1.23 percent average being charged by junk bond mutual funds.


Benefits of High Yield Bond ETFs

--Reduction of risk exposure to individual bonds

--Laddering bond maturities is an automated feature

--Lower expense ratios vs. junk bond mutual funds

--Intraday liquidity


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