Comprehensive Guide to U.S. Junk Bond ETF Investing

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Despite the low rate environment, the bond market is seeing a great deal of popularity as of late.

By Zacks Investment Research

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 (Read: Forget T-Bonds, Invest in These Top Corporate Bond ETFs).

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 (Read: Do You Need A Floating Rate Bond ETF?).

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 (Read: Follow Buffett With These Developed Market Bond ETFs).

Peritus High Yield ETF (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 (Read: Could The Small Cap Healthcare ETF Be A Great Pick?).

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 (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 (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 (Read: iShares Debuts Two High Yield Bond ETFs). 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 (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 (Read: Play A Consumer Recovery With These Discretionary ETFs). 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 (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.

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