November was a scary month for bond investors.
The Bloomberg Barclays Global Aggregate Total Return Index fell 4% in November, shedding a record $1.7 trillion in value.
[ad#Google Adsense 336×280-IA]That loss ranks as the worst monthly performance since the index was created in 1990, more than 26 years ago.
And some of the “safest” bond-related ETFs in the market fared even worse.
The iShares 20+ Year Treasury Bond ETF (Nasdaq: TLT) was down 8% in November for a total of almost 20% since July.
Similarly, the iShares 7-10 Year Treasury Bond Fund (NYSE: IEF) is down 9% from its 52-week high and the iShares IBoxx Investment Grade Corporate Bond Fund (NYSE: LQD) is down 7% from its 52-week high.
These losses are being driven by a tectonic shift at the Federal Reserve — the central banking system that controls U.S. interest rates. For the first time in 10 years, the Fed has raised interest rates.
This has big implications for bond investors — when interest rates go up, most bond prices go down. This is what triggered the huge capital outflow from bonds in November, as investors were pricing in a rate hike. A lot of short-term capital that was parked in bonds quickly hit the eject button to dodge falling prices.
Looking forward, it’s likely the Fed will continue raising rates. Interest rates tend to move higher or lower in multi-year cycles. If rates advance further, many classes of bonds could fall further, including Treasuries and investment-grade corporate bonds.
That’s why this is the best time in 10 years to check out one of the most misunderstood classes of bonds. Not only do these bond prices have a strong history of advancing when interest rates rise, their 5.5% current yield is one of the best yields in the entire global bond market.
iShares iBoxx High Yield Corporate Bond (NYSE: HYG) is one of the most heavily traded and liquid bond ETFs in the world. It has $17.8 billion under management and average daily trading volume of 1.26 million. The fund is designed to correspond to the performance of the iBoxx $ Liquid High-Yield Index.
High yield bonds are generically referred to as junk bonds on the Street. But this name is misleading, particularly right now. I see two reasons why this is the best time in 10 years to invest in junk bonds and particularly HYG.
Junk Bonds Appreciate In Value When Interest Rates Rise
HYG is one of the few bonds that actually appreciates in value from rising interest rates.
The reason is simple. Junk bond companies are more indebted than their investment grade counterparts. These companies use more leverage on the balance sheet, making them more sensitive to economic cycles.
Rising interest rates typically reflect strong economic growth. When the economy is strong, it becomes easier for indebted companies to satisfy their monthly debt payments. That’s why junk bonds and HYG typically prosper when interest rates are rising.
And that’s exactly what has been unfolding. In the last month, HYG’s value is about even while the “safe” iShares Treasury Bond is down 10%. Take a look below.
You’ll see that, under current economic conditions, junk bonds may not be so junky. In addition to capital stability, junk bonds offer some of the highest yields available in a low-yield market.
That once again tracks back to the balance sheet. Companies with higher amounts of debt and leverage are considered higher bankruptcy risks. Bond investors demand a higher rate of return to lend cash to these companies through bond purchases. This distinction makes junk bonds among the highest yielding bonds in the U.S and globally and a favorite with high-yield investors.
HYG’s current yield of 5.5% is more than double the Vanguard Bond Index Fund’s (NYSE: BND) and S&P 500’s respective 2.5% and 2.0% yields.
Investors should also pay attention to fees on mutual funds and ETFs. Lowering fees will help improve returns. On that front, HYG’s annual expense ratio of 0.50% is in line with the category average.
Risks To Consider: High-yield bonds carry higher credit risk than investment-grade corporate and Treasury bonds. Although defaults have been trending lower in the past three years, turbulence and weakness in the global economy increase the probability and volume of credit events.
Action To Take: HYG offers bond investors protection against rising interest rates. That makes this the best time in 10 years to invest. Its 5.5% dividend yield ranks among the highest in the world. Buy shares below $90.00 and collect an outsized and reliable dividend.
— Michael Vodicka
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Source: Street Authority