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Digging for High Yields in the Junk Heap

Scott Burns

Scott Burns: Digging for high yields in the junk heap. Hi, I am Scott Burns, director of ETF analysis with Morningstar. Today, we are going to talk about investing in junk bonds using ETFs. Many individuals out there know that ETFs are great for sector investors or other niche type investing, but one of the fastest growing areas in the ETFs is actually the slicing and dicing in the fixed income space.

And no space in fixed income really lends itself more to the full benefits and powers of the ETF structure than junk bonds--primarily diversification, which ETFs bring and allow investors to own a broad basket of these highly risky securities. This means that should one of the bonds in the fund go bankrupt or go into trouble, you have the benefit of diversification across hundreds of holdings to help offset that loss.

So, although it doesn't help when you have trouble in the credit markets, even in junk bonds, it does help minimize some of the pain compared to if you just owned a single junk bond or several junk bonds.

Now, when we look at the high yield space in ETFs, there are two primary players. There is the iShares iBoxx High Yield Corporate Bond ETF with the ticker HYG and the SPDR Barclays Capital High Yield Bond, with the ticker JNK--very aptly named, we can think of that as short for junk.

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So, when we look at these funds and take a look at the fundamentals, it's very interesting to note that although the yields have really come in from the highs that they experienced last October, when they got as high as 18 percent, the credit spreads are still quite wide. In fact, right now, between the two funds, the average credit spread to a similarly laddered and durationed Treasury bond ETF, is around 750 basis points.

Now, to put that in perspective, in the 10 years prior to the credit crisis, the average junk bond spread was around 584 basis points. So, as you can see, there is some extra yield in there, but that yield is there to help compensate for the risk. So, folks want to make sure that they are comfortable holding these highly risky securities before they look to invest.

Another thing to remember about junk bonds is that they are much more correlated to stocks than most people would assume fixed income to be. And that's because they are really not that far in the capital structure from equity. So when you are investing in a high yield ETF, even with the diversification, it's important to know that these are really a broad basket of highly levered securities.

Another thing worth noting about the junk bonds ETFs is that the average duration on the fund has actually come in quite a bit. It's announced somewhere around 4.6 years, 4.4 years, depending on which fund you are looking at. Comparatively, the iShares iBoxx Investment Grade Corporate Bond ETF, or LQD, is seen at around seven years. What that means is that with the shorter duration, the exposure to inflation risk is actually a lot smaller with these funds. And that duration has come in quite a bit, because the coupon payments are so high that the total value you would receive from this basket of bonds is actually being achieved earlier in the life cycle of the bonds rather than waiting all the way to the end with principal payment.

So, for investors with a high risk tolerance who think that the worst of the credit crisis and the recession are behind us, these funds offer some very high yields, even when we look back at historical averages. But remember that risk and return are always in balance and that with those high yields, still comes quite a bit of credit risk out there. And not all these companies are out of the woods yet.

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