Time To Buy Junk Bond ETFs?

June 29, 2011

After a sell-off of riskier assets in June, investors looking for a rebound might want to give high-yield bond ETFs a closer look.

Junk bonds have performed almost as poorly as stocks this month, as investors moved into less risky plays. Treasurys posted their 11th straight week of gains last week, and issuance of new corporate bonds fell 24 percent from the prior week. It’s pretty clear that only the safest bonds are attracting investors right now.

The S&P 500 has dropped about 2.7 percent in June, and junk bonds haven’t fared much better. That’s because junk bonds offer a play on risk. The flip side is that if investors decide the market sell-off has been too much, high-yield debt is likely to bounce back right along with stocks.

But what is the best junk bond fund for investors?


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The largest high-yield bond fund is the iShares iBoxx High Yield Corporate Bond Fund (NYSEArca: HYG). It has more than $8 billion in assets. Due to its size, HYG has experienced the largest outflows over the past month, with $602 million in redemptions. The fund offers investors the most diversified portfolio of high-yield bonds, with 465 holdings, at a 0.50 percent expense ratio.

The second-largest high-yield bond fund is the SPDR Barclays Capital High Yield Bond (NYSEArca: JNK), with over $6.7 billion in assets. JNK offers investors a cheaper alternative with an expense ratio of only 0.40 percent, but is currently invested in only 197 holdings.

Both HYG and JNK weight holdings based on market value of debt outstanding. This causes the two portfolios to be overweight companies with a large amount of debt. While a high-yield portfolio is meant to include investments with a large amount of debt, a market-value-weighted portfolio overweights the companies that could be more likely to fail.

The PowerShares Fundamental High Yield Corporate Bond Fund (NYSEArca: PHB) offers investors an alternative to market-cap-weighted indexes. PHB tracks the RAFI High Yield Bond Index which, after separating out the high-yield investments, selects based on four factors: book value of assets, gross sales, gross dividends and cash flow.

The RAFI Index allows investors to invest in a high-yield bond portfolio without overweighting the riskier companies. With $500 million in assets and a 0.50 percent expense ratio, PHB might be perfect for investors with a long-term time horizon. The funds’ returns through June 27, 2011 were:

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The Peritus High Yield Fund (NYSEArca: HYLD) from AdvisorShares is an actively managed high-yield fund that chooses companies that provide the best current income stream. It hasn’t been on the market long enough to know if its returns will hold up over the long run, but it has outperformed the other high-yield funds over the past six months.

But HYLD's relatively high expense ratio of 1.35 percent means it will have to consistently outperform the other ETFs by upward of 1 percentage point just to stay ahead of them.

The riskier companies are likely to be the ones that benefit the most from economic improvement. For investors looking to profit over short periods of time, JNK might be the best alternative with the lowest expense ratio and a smaller, riskier portfolio that would probably rise the most when markets regain their appetite for riskier investments.

Long-term investors, though, will benefit from PHB’s weighting structure. The fund provides a great way to achieve high yields without taking on too much risk.


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