An ETF for High Yield Corporates

Carla Pasternak Editor, The Income Investor

Despite a bear market for bonds in the face of rising interest rates and inflation expectations, one corner of the fixed income market is thriving. High-yield corporate bonds returned a robust 23% this past year, on pace with the S&P 500, observes Dr. Carla Pasternak, editor of Dow Theory Letter's The Income Investor.

Popularly known as “junk bonds,” these sub-investment grade debt obligations are rated BB+ or below by Standard & Poor’s. They currently offer average yields of 6% in return for their higher risk of default than investment grade bonds.

What about rising interest rates? Typically, bonds lose value as interest rates rise. However, high-yield bonds are different. Their above-average yields and generally shorter maturities tend to make them less sensitive to the early stages of a gradual rate rise.

In fact, the initial round of rates hikes tends to be a positive for high yield bonds. Rising rates suggests the economy is strengthening, and that means lower default rates for corporate issuers.

High yield ETFs allow you to invest in the entire sector. While ETFs don’t provide return of principal, they do offer steady robust monthly dividend payments and potential capital gains as you rotate in and out of the sector.

With $19 billion assets under management, the iShares iBoxx $High Yield Corporate Bond ETF (HYG) is the largest ETF in the corporate high-yield category.

The fund’s benchmark index includes highly liquid,, dollar-denominated bonds. To ensure trading liquidity, there must be at least a $400 million issuance of these bonds and they must mature within 15 years.

About half the 1,000 bonds in the portfolio carry  a credit rating of  BB, just below investment grade. The  average credit quality is a mid-tier speculative  B and the average yield to maturity is 5.40%. Duration, a measure of interest rate sensitivity,  is a low 3.9 years. 

Monthly dividend payments totaling $4.56 per share over the past year gives a trailing yield of 5.2% at today’s price ($4.56/$87.29). The latest payout of $0.29 is down from previous monthly payments of $0.38 to $0.40 due to lower interest rates.

Distributions consist entirely of interest income from the bond holdings and are taxable as ordinary income at your marginal tax rate. They do not qualify for the reduced dividend tax rate, so  the fund is best held in a tax-deferred IRA type of account. A 0.50% management expense ratio (MER) takes a bite out of total returns.

The fund’s performance has varied greatly, depending on the economic and equity market environment. It returned 29% in the recovery of 2009, a negative 5% in the recession of 2015, and bounced back to 13% as the economy and stocks improved in 2016.

Technically, HYG has been in an accelerated uptrend since February 2016.

Chart

The shares have held above rising  40-week and 10-week moving averages for most of this time, and they are currently trading above these averages. Long-term resistance just below $83 since mid-2014 was broken in mid-2016, and now provides support.

On a cautionary note, volume has been declining on the latest leg of the rally that began in November, and the shares have consolidated above $87 for the past month.

As well, after rising sharply through most of 2016, MACD is now flat—but still above the zero line. RSI showed strength, holding near 50 on a pullback in November. It is not over-bought below 70.

While capital gains may be more modest this year than in 2016, the ETF should continue to offer above-average interest income with limited default risk. Our short-term stop loss is $82.45 -- below long-term support and the 40-week moving average. 

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