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Under the Hood of SPDR Barclays High Yield Bond ETF

It offers an attractive yield but is heavily concentrated in the industrials sector.

John Gabriel, 12/27/2014

For strategic, long-term exposure to U.S. high-yield bonds, investors may consider SPDR Barclays High Yield Bond ETF JNK as a small core holding. The fund can also serve as a tactical investment for the satellite portion of a diversified portfolio. Investors should bear in mind that high-yield bonds are one of the most volatile sectors of the fixed-income market.

Long-term-minded investors looking to JNK as a strategic position are likely to find the diversification benefits of high-yield bonds attractive. High-yield bonds tend to be negatively correlated (or uncorrelated) with government and aggregate bond portfolios, which often make up the bulk of most investors' fixed-income exposure. Moreover, high-yield bonds are poised to hold up relatively well in the event of rising interest rates and inflation. While rising rates and inflation tend to be the enemy of typical fixed-income securities, the high-yield bond asset class tends to outperform its fixed-income peers during such periods thanks to its stocklike returns and heavier dependence on business fundamentals. Consider that over the past 10 years, U.S. high-yield bonds have shown positive correlation (74%) with the S&P 500, while the Barclays U.S. Aggregate Bond Index has been relatively uncorrelated (26%) over the same period. Remember, interest rates will typically rise when the economy is in good shape and businesses are performing well. High-yield bonds tend to perform well when issuers' fundamentals are strong or improving (and vice versa).

Tactical investors may look to a fund like JNK as a way to bolster income in a yield-starved environment. However, investors should not look at the fund's yield in isolation. Rather, the current yield should be viewed in relation to the yield offered by U.S. Treasuries with the same maturity. The difference between the two is what is known as the credit spread, and it represents the premium that investors can collect for assuming additional credit risk.

The credit spread should also be viewed relative to the expected default rate. According to Moody's, since 1983 the historical average default rate for high-yield bonds is 4.8%. In the trailing 12-month period through October 2014, the U.S. high-yield default rate was 2.4%, relatively flat from a year ago. Rising default rates typically result in widening credit spreads. But default rates are expected to remain low (around 2%) thanks to favorable credit conditions.

Fundamental View
The U.S. high-yield bond market has evolved over the past few decades. Whereas in the 1970s the overwhelming majority of high-yield bonds were so-called "fallen angels" (bonds issued by companies that had their credit ratings downgraded from investment-grade to high-yield status), today there is a vibrant and healthy market for new-issue high-yield bonds. According to SIFMA, in 2014, new issuance of high-yield bonds in the United States was $278 billion through October, slightly below the $285 billion sold in 2013 in the same period. By comparison, high-yield issuance averaged $95 billion per year from 1999 to 2009.

Many investors may find the significant income potential of U.S. high-yield bonds attractive, particularly in the current low-yield environment. Their income potential is a primary point of appeal that attracts investors to the high-yield corporate-bond market. Indeed, there are very few other investments that offer high- to mid-single-digit yield potential in the current market environment. But other factors to consider include the asset class' diversification benefits as well as its ability to withstand the impact of rising interest rates, potential inflation, and an uptick in the instance of default.

U.S. high-yield bonds offer a favorable risk/reward profile relative to other major asset classes thanks to their equitylike returns with significantly less volatility. Owing to its generous yield, the Bank of America Merrill Lynch High Yield Master II Index (the generally accepted benchmark for the asset class) generated an annualized total return of 7.6% over the past 15 years. This compares to a total return of about 4.6% for the S&P 500. But the BofAML HY Master II Index’s annual standard deviation over that period was 9.9%, compared with 15.3% for the S&P 500.

Adding a stake in high-yield bonds to complement aggregate bond exposure can help improve a portfolio's diversification benefits. In fact, over the past five years, high-yield bonds have been uncorrelated (12%) with the Barclays U.S. Aggregate Bond Index. The asset class's lack of correlation with investment-grade bonds and its negative correlation with government bonds should be an advantage when we finally see the inevitable rise in interest rates and potentially higher inflation.

John Gabriel is an ETF strategist with Morningstar and contributor to Morningstar ETFInvestor. Click here for a free issue.

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