The current market environment has been very challenging for the income investors. Traditional income assets like treasuries, investment grade bonds, CDs and bank deposits currently produce miniscule yields. As a result, many yield-starved investors have flocked to riskier assets like junk bonds.
“Junk” or “high-yield” bonds usually pay ~5% above treasury bonds but the higher yield comes with a much greater risk of default. So far the defaults have remained very low and thus the investors have continued to pour money into junk bond ETFs—which are the most convenient way to invest in this asset class.
As a result the yields have plunged to multi-year lows and the credit spreads have narrowed. As the bond prices and yields move in opposite directions, the junk bond investors reaped handsome profits during the past few years. (Read: 4 Best ETF Strategies for 2013)
But junk bond investors beware--the situation is likely to change this year. The minutes of the FOMC meeting released yesterday suggest that many members are concerned about the potential risks of continued asset purchases by the Fed. As a result, the Fed may slow-down its asset purchases earlier than previously thought.
If the rates start to rise, the bond market rally will finally come to an end. The ten-year note has already broken the psychological barrier of 2% this year. Within the fixed income space, junk bonds appear to be at highest risk.
Looking at the current spread between the junk bond yields and S&P 500 earnings yield, the junk bonds look extremely expensive as present.
Further, considering the relative illiquidity of the junk bond market, the reversal in this market could be much faster in the event of rise in interest rates. (Read: The Right and Wrong Ways to Invest in China ETFs)
As a result of concerns about a possible bubble in the junk bond markers, many large institutional investors have pared their junk bonds holdings or even taken short positions in the market recently. Retail investors are also slowly beginning to withdraw money from the junk bonds funds.
So, it may finally be the time when the junk bond ETF investors should start looking at much better options available to them.
At current valuations, stocks look much more attractive than bonds and will deliver much better returns in the longer-term. Most large US blue chips are sitting on piles of cash and are in position to increase dividends. High quality dividend ETFs currently have ~2.5% dividend yield and excellent longer-term capital appreciation potential. (Read: 4 Excellent Dividend ETFs)
But if you are looking for yields comparable to junk bonds, here are some better options.
CVY follows the Zacks Multi-Asset Income Index, which is comprised of approximately 125 to 150 securities selected using a proprietary methodology, from a universe of domestic stocks, ADRs, REITs, MLPs, CEFs and preferred stocks.
In terms of asset-class breakdown, the ETF is tilted towards US stocks (70%), with about 17% allocation to international stocks.
By investing in diverse asset classes, which have low correlations, this ETF actually reduce volatility and provide stability to the portfolio. Diversified portfolios in general deliver superior risk-adjusted returns over the longer-term.
The product charges 60 basis points in annual expenses and pays out 5.1% yield currently.
PowerShares Emerging Markets Sovereign Debt Portfolio (PCY)
PCY is based on the DB Emerging Market USD Liquid Balanced Index, which tracks liquid emerging markets U.S. dollar-denominated government bonds issued by 22 emerging-market countries.
The case of investing in emerging markets' sovereign debt seems to be pretty strong now. Many emerging countries now have better fiscal health and lower debt levels than developed countries.
Further these countries are growing at a much higher rate compared to the developed world and have low correlations with developed economies.
And, while interest rates are at rock-bottom levels in the U.S., the emerging countries’ central banks still have the flexibility to cut rates further, providing great chances for capital appreciation.
Launched in November 2007, the product has already attracted more than $2.5 billion in assets. It charges the investors 50 basis points in annual expenses and currently pays out a yield of 4.8%
AMJ is the most popular MLP ETN in the MLP space with over $5.5 billion in assets under management and daily volume over 1.6 million shares a day. The ETN which seeks to track the Alerian MLP Index was launched in April 2009.
The note charges the investors 85 basis points a year in fees for its services but rewards the investor with a very attractive 4.7% yield.
In addition to high yield and the potential for capital appreciation, MLPs also have lower volatility and provide diversification benefits to the portfolio. Further MLPs in general are less risky than other plays in the broader energy space.
We may however add that MLPs are a complicated asset class and the investors should understand the tax related and other issues before investing. Further JP Morgan has capped the new share issuance for this ETN so the investors need to make sure that ETN is trading close to its NAV before investing.
CVY
PCY
AMJ
HYG
YTD return
6.3%
(3.5%)
13.9%
0.07%
3 Year return
50.5%
40.7%
73.5%
33.4%
3 Year Std.Dev.
12.6%
7.3%
15.6%
8.1%
12 month yield
5.1%
4.8%
4.7%
6.6%
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