As part of a diversified fixed-income portfolio, investors may consider including a small tilt toward high-yield, junk-rated bond exchange traded funds.
“For strategic, long-term exposure to U.S. high-yield bonds, investors may consider e SPDR Barclays High Yield Bond ETF (NYSEArca: JNK) as a small core holding,” writes Morningstar strategist John Gabriel. “The fund can also serve as a tactical investment for the satellite portion of a diversified portfolio.”
While junk bond ETFs may provide attractive yields – JNK has a 6.12% 30-day SEC yield, investors should not go overboard with their exposure levels. High-yield bonds are still one of the most most volatile sections of the fixed-income market. [Use ETFs to Maintain Your Core Bond Exposure]
Nevertheless, high-yield bond ETFs can help diversify a portfolio. Junk bonds tend to be negatively correlated with government and aggregate bond portfolios. Additionally, high-yield debt may also hold up relatively well in a rising rate environment and provides a larger cushion against the negative effects of 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,” Gabriel added.
Tactical investors may also capitalize on short-term trends with high=yield bonds and bolster income in a low-yield environment. However, Gabriel advises traders to look at the yield relative to U.S. Treasuries as a proper gauge of valuations – the difference between the two yields is known as the credit spread.
Lastly, investors should consider the average default rates in the space. According to Moody’s the average default rate for high-yield bonds is 4.8% since 1983. Over the past twelve months through October 2014, high-yield defaults were 2.4%. Rising default rates can also correspond with widening credit spreads.