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An Opportunity in High Yield Bonds

by: Larry MacDonald April 01, 2008 | about stocks: HYG / JNK / PHB    
Larry MacDonald

Larry MacDonald

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The flight from risky assets during the current financial turmoil has knocked down the prices of U.S. junk bonds and left their effective yields in the 8% to 10% range. Assuming risk aversion will eventually return to normal levels, those kinds of yields may look attractive to some income investors -- especially since three new exchange traded funds (ETFs) make it easy to buy into diversified baskets of high-yield bonds. The three ETFs are:

SPDR Lehman High Yield Bond ETF (JNK)

iShares iBOXX $ High Yield Corporate Bond (HYG)

PowerShares High Yield Corporate Bond (PHB)

One might consider accumulating on the dips, as could occur on more flare-ups in concerns over the financial system. In addition, the recession is in its early stages so there could be some dips on news of bond defaults. Currently, the default rate on high-yield corporate bonds is near a cyclical low of 1.25%, compared to a peak of 8% during the last recession.

For Canadians there would be currency risk from owing the above ETFs. It would seem, though, the Canadian dollar has more or less topped out. In fact, it may be due to trend downward given commodity prices, now at historically high levels, could correct in response to the U.S. recession.

Footnote: Yields for bond ETFs quoted by online financial sites can be misleading as they may simply annualize the last monthly or quarterly payment. For a bond ETF just starting out (when payouts are initially low) or experiencing a transitory dip, this calculation will understate the yield. The iShares iBoxx ETF, for example, shows a yield of 6.5% on Yahoo Finance while other calculations (as reported on the iShares website) show yields closer to the 10% level.

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