Christopher Raby, The Daily Record Newswire
As the prospect of higher interest rates looks like it’s getting pushed further and further into the future, finding value and yield in fixed-income assets is a challenging proposition. Because of the risk of rising rates, many yield-hungry investors have opted away from longer-dated, investment-grade securities in favor of short-dated, junk-quality bonds.
While this strategy will certainly increase portfolio yield, undue exposure to junk bonds can be perilous to long-term investors. However, one of our favorite strategies provides some downside protection while finding value in the inefficiencies of the market.
Investors seeking exposure to high yield corporate bonds have several methods of investment. Individual bonds, ETFs, open-end bond funds and closed-end bond funds all provide varying levels of exposure to the high yield corporate bond market. Each method of investment has both benefits and drawbacks.
Individual investors often find investing in individual bonds difficult. While careful analysis may uncover hidden value in a particular bond issue, many individual investors simply do not have the time to perform the necessary research to compete with professional analysts. Furthermore, a portfolio structured with only a few individual corporate bonds may not have proper diversification. Also, the structure and liquidity of the high yield bond market makes individual bond investing impractical for many individual investors.
Exchange-traded bond funds (ETFs) and open-end bond funds provide exposure to a broad array of high yield bonds, while mitigating the problems an individual investor often faces in individual-bond investing. Investors are able to obtain the benefits of proper diversification, while accessing professional portfolio management in both open-end funds and (more recently), ETFs.
While open-end funds trade at the value of securities in the underlying value of the portfolio (called NAV), ETFs have the potential to trade at values different from NAV.
Recently, popular ETFs such as the SPDR Barclays High Yield Bond ETF (JNK) and the iShares IBOXX High Yield Bond ETF (HYG) have actually traded at slight premiums to their NAV.
Conversely, closed-end funds, the predecessors to ETFs, also have the ability to trade at prices different than NAV. In the past few years, many yield-hungry investors pushed the high yield closed-end bond fund market values above the fund’s NAV. Spooked by the rise in rates earlier this year, many of these same funds saw premiums erode and discounts widen as investors fled the funds. The funds have begun to trade at discounts of 15 to 20 percent of NAV. The funds, whose underlying portfolio offers similar risk exposure as their open-end and ETF counterparts, are currently some of our favorite buys.
Further, the high yield closed-end bond fund market is generally divided into two subsectors: traditional high yield and senior loan funds. Both funds own securities that are rated below investment grade, but the difference comes from the characteristics of the underlying bonds.
The traditional high yield funds typically own bonds with a fixed rate for a fixed duration, which generally ranges from 5 to 10 years. The senior loan funds typically own bonds with a variable rate that resets over a much shorter time period – often as little as a week. Essentially, senior loan funds offer exposure to credit risk without duration risk.
While considerably uncertainly exists in the fixed income markets, the pockets of value still exist. As demonstrated, the investment vehicle decision is an important component of the investment process and can provide value in itself. Further, understanding the characteristics of the securities in which you’re invested is critically important as well.
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Christopher Raby is a senior taxable fixed manager/fixed income analyst for Karpus Investment Management, anindependent, registered investment advisor managing assets for individuals, corporations, nonprofits and trustees. Offices are located at 183 Sully’s Trail, Pittsford, N.Y. 14534; phone (585) 586-4680.
