By: Joseph Hogue of Street Authority
The great bond exodus may have begun. Fears of Federal Reserve-induced interest rate increases are pushing bond yields up and bond prices down.
In fact, more than $1.2 trillion in value has been wiped out in the global bond market since April.
The selloff has accelerated when the June employment report showed that wages in May increased by the most since August 2013.
Signs of an economic recovery in Europe have also pushed losses on global bonds even further. The yield on the German 10-year bund has jumped nearly ten-fold since late April.
The fallout is already being felt with bond funds. The iShares 20+ Year Treasury Bond Fund (NYSE: TLT) and the SPDR Barclays Long-term Corporate Bond ETF (NYSE: LWC) have both lost roughly 10% in the past two months.
Despite the idea that bonds are a safe investment and a hedge against stock market losses, the correlation between global bonds and stocks has recently increased to 0.30, the highest correlation since the Federal Reserve announced it would begin tapering quantitative easing in 2013. That means returns on stocks and bonds are moving in similar directions and there may be nowhere to hide for investors.
Looking for safety among dividend payers? Well, higher fixed income rates may pull some funds away from dividend-paying stocks. Higher interest rates may also mean less corporate borrowing, which could slow the torrid pace of stock repurchases and dividend increases in the market.
While investors are hoping the Fed will slowly raise rates when the first increases hit later this year, there's no consensus on how high rates could go. Ten-year rates were as high as 5.25% in 2007, more than double the current rate. And the rate was over 6.5% at the turn of the millennium. If rates were to return to those levels, bonds would no longer be a safe investment.
But it turns out there might be one segment of the market that remains relatively safe from higher rates. The segment pays yields more than twice that of the U.S. 10-year Treasury and it's probably one of the last places you'd think to look for safety.
One Man's Junk Bonds Is Another Man's Treasure
The Bloomberg US High Yield Index yields 6.74% against 3.3% on corporate bonds and a 1.93% yield on the SP 500.
Non-investment grade debt, or junk bonds, is not highly correlated with other corporate bonds or interest rates because the dominant risk in the investment is issuer solvency, rather than rate competitiveness. A recovering economy means higher interest rates, but it also means lower-rated companies will be able to make their debt payments.
High yield bonds are also less sensitive to an increase in interest rates because they mature much more quickly. While investment-grade bonds may be issued for periods of 30 or even 99 years, most high-yield debt is issued for 10 years or less. This has helped the high yield index maintain an average yield that has averaged nearly six percentage points above U.S. Treasuries since 1987.
The SPDR Barclays High Yield Bond ETF (NYSE: JNK) is down 1.6% since late April. The shares pay a 5.7% yield and have generated a compound annual return of 7.6% over the last five years. The fund is diversified across 803 different bond issues with an adjusted duration (i.e. the maturity of bonds held) of just 4.38 years.
The iShares iBoxx High Yield Corporate Bond ETF (NYSE: HYG) is also down 1.7% since late April. The shares pay a 5.4% yield and have returned a compound annual return of 7.9% over the last five years. The fund is diversified across 1,026 different bond issues with an adjusted duration of just 4.13 years.
The two funds are similar, but I slightly prefer the SPDR Barclays fund, thanks to its 0.40% expense fee, against the 0.50% fee on the iShares fund. The Barclays fund also has a slightly higher yield.
To be fair, high-yield bonds are not completely immune from an increase in rates. A sudden surge in interest rates will weigh on junk bonds as volatility increases. During the taper tantrum of 2013, both of these funds fell just over 3% from May to September. That was still relatively attractive against a loss of 12.9% on the iShares 20+ Year Treasury Fund and a loss of 10.7% on the SPDR Long-term Corporate Fund. A big jump in rates like we saw in 2013 is not likely to happen as quickly and a better economic outlook should help support prices for high yield bonds.
Risks To Consider: High-yield bonds will drop in value when the next recession hits. Signs point to good economic growth over the next year, but investors will want to watch the business cycle.
Action To Take -- Take advantage of higher yields and relative safety in high yield bonds to protect your portfolio from higher rates and stock market volatility. JNK is my preferred fund, but other options remain viable.
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