Junk Bond Yields Are Falling. Should Investors Get Picky?

In scrambling for more yield, investors are, not surprisingly, embracing high-yield corporate debt. However, inflation is taking a bite out of junk bond returns, indicating investors could get selective in this corner of the bond market.

One way of accomplishing that goal is with the Invesco Fundamental High Yield® Corporate Bond ETF (PHB). The $844.4 million PHB follows the RAFI Bonds US High Yield 1-10 Index. As is the case with any index, methodology matters.

PHB’s underlying benchmark has avenues for setting itself apart that could be useful to investors at a time when inflation is weighing on junk bonds.

“A rally in corporate debt rated below investment grade has pushed yields to record lows around 4.57%, according to ICE Bank of America data through Thursday, while consumer prices rose 5% in May compared with a year earlier. That marks the first time on record junk-bond yields have dropped below the rate of inflation, according to Bespoke Investment Group,” reports Julia Ambra-Verlaine for the Wall Street Journal.

Points in Favor of PHB

PHB has a 30-day SEC yield of 2.23%, well below the yield mentioned above. However, that’s not strike against the Invesco fund.

While now may seem like the time to embrace the junkiest junk bonds – those with CCC ratings or lower – markets can shift on a dime, punishing speculative fare along the way. For its part, PHB leans into quality by only holding debt rated B or above. Seventy-eight percent of the fund’s 193 holdings are rated BBB or BB.

Compounding PHB’s quality purview is that bonds in the fund are weighted by dividends, generated cash flow, and book value of assets. Those qualifiers can serve to mitigate default risk among PHB components.

“Traditional bond indices, which are weighted by the amount of debt outstanding, may not always be optimal for passive solutions. In traditional indices, the most indebted issuers receive the largest index weights. Weighting according to the debt appetite of bond issuers can leave investors overexposed to firms with poor credit quality, without compensation for the added risk they take on,” according to Research Affiliates, PHB’s index provider.

While PHB isn’t the highest yielding junk bond ETF out there, it is credibly levered to a recovering U.S. economy because consumer discretionary and energy debt accounts for about a third of the fund’s weight. Ninety-six percent of the fund’s holdings have maturities of one to five or five to 10 years.

PHB 1 Year Performance

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The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.