Monday, August 02, 2010

Junk Bond ETFs and Funds

There's no free lunch. But these days Junk Bond ETFs are giving investors healthy returns and little indigestion.

Reliable income and capital preservation

Successful high-yield investing through bond funds and High-yield bonds, though alternately seen as either sleepy or risky, can serve as part of a core investment strategy, especially during times like ours, when exuberant equity expectations have been subdued and look like they will remain that way for a while.

More investors are looking for reliable income, and capital preservation has become at least as important as -- if not more than -- performance. Higher yields and income become back-to-basics staples among investors during times of austerity, and so the renewed interest in high-yield bonds has not been unexpected.

However, the high-yield market, though not as persistently volatile as stocks, can be suddenly punishing as well as rewarding. High-yield bond prices have generally correlated with the equity markets, as investors link high-yield default risk ahead of interest-rate risk. The inverse has also been true: Generally, when the stock market goes up, so do high-yield bonds as good times diffuse the risk of default. But when investors sense the risk of defaults rising, they will dump the high-yield sector just as fast, as they did in 2008.

No individual bonds

Trading the high-yield market -- and not individual high-yield bonds -- can offset this risk. This means trading high-yield funds and exchange-traded funds to avoid the surprises often associated with individual bonds. It also means developing and sticking to a long-term, time-tested strategy to avoid high-yield bonds altogether when the trend is unfavorable. Enjoying the high-yield payouts -- with traditionally generous dividends -- while avoiding the downtrends, can make for a more profitable combination. Even when missing a trade in one of these high-yield bond funds, the yield itself can more than make up for it.

To successfully trade high-yield funds and ETFs, there are several data points that need to be correlated and monitored. These include price and volume, of course, but also other easily retrievable data, such as closed-end bond premiums or discounts, and high-yield bond new highs and new lows.

These data, when taken together, smooth out extreme indicators in the high-yield market while providing a generally reliable overall indicator that can serve as a trend line; in other words an algorithm. Trading high-yield funds and ETFs does not mean we ignore high-yield spreads against Treasurys or other bond market indicators, but spread-watching is not a primary preoccupation.

Tortoise and hare

Active, though not frequent, trading along the lines of these simple data points with the underlying algorithm has admittedly underperformed equities, sometimes for months on end, but it has outperformed equities significantly in the long run. It's the tortoise and the hare story, and the cycle often repeats just when you think equities are going to run away with the glory.

For the High-Yield ECM Strategy at Garrett Capital, we've used this method since the 1980s, and though we've made slight adjustments over the years, relying on these has ensured that the strategy has not had a losing year. In 2008, for example, this high-yield strategy turned in a positive performance when most indexes -- whether of equities or high-yield bonds -- were down dramatically. And, as many have found, the impact of a large loss on long-term performance is stultifying. Making your money back after big losses takes time.

In recent years more high-yield offerings have become available to investors including ETF's such as the iShares iBoxx $ High-Yield Corporate Bond Fund /quotes/comstock/13*!hyg/quotes/nls/hyg (HYG 88.48, -0.14, -0.16%) , with over $5 billion in assets; the SPDR Barclays Capital High-Yield Bond /quotes/comstock/13*!jnk/quotes/nls/jnk (JNK 39.30, -0.12, -0.30%) , with more than $3 billion in assets; and the PowerShares High-Yield Corporate Bond /quotes/comstock/13*!phb/quotes/nls/phb (PHB 18.09, +0.02, +0.11%) with assets just less than $200 million. These, coupled with many closed-end and open-end high-yield bond funds, provide investors with plenty of choices to enter the high-yield market without having to wonder if an individual bond is worth the investment.

Now is the time to keep an eye on how well high-yield bonds correlate with equity indexes, and on a day-to-day basis. If the high-yield market outperforms, that's usually positive for equities. If the high-yield market responds well when equities drop, think twice about being short: It's likely a signal that equities are ready to rally along with the high-yield market.

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