High Yield Corporate Bond ETF

H

honkytonk

Guest
Hi,

I'd appreciate any feedback on potential downsides to investing in a High Yield Corporate Bond ETF, specifically SPDR Barclays Capital High Yield Bond ETF (JNK). Dividend yield is currently 7.8%. Annual fee 0.5%.

I'm thinking of investing approx 10% of my portfolio in this ETF. The rest of my portfolio is made up of three other equity ETFs plus four company stocks. I've been investing since 1998. Strategy is long term hold.

From my own perspective the downsides to the High Yield Corporate Bond ETF are:

Currency risk (bonds/ETF are $ denominated)
Risk of individual bond defaults - which should be low as the ETF is composed of 221 holdings.
Risk of mass defaults. The bonds are by their nature, not "investment grade"
Underlying ETF price will not appreciate (accepted on the basis that investment is for yield, not growth)

I'd appreciate your thoughts.

Thanks
 
This is a really bad idea.

Aside from the Us dollar exchange risk and default risks you have already identified you are also buying a fund which is domiciled outside the EU so you also get a tax disadvantage to boot.

Chasing yield is a bad idea generally.

The Stock-Bond Decision

Choosing a basic stock-bond mix is an important first step in portfolio design. Although the decision may appear simple, it can have a profound impact on your wealth.

Portfolio theory explains the value of making a deliberate, strategic decision about the proportion of stocks versus bonds to hold in a portfolio. This decision has roots in the “separation theorem,” which was proposed by Nobel laureate James Tobin in the late 1950s.1 The separation theorem proposes that all investors face two important decisions:
(1) deciding how much risk to take, and then
(2) forming a portfolio of “risky” assets (equities) and “less risky” assets (fixed income) to achieve this risk exposure.

Your stock-bond decision implements this risk position.

The Rationale
The theorem proposes that all investors who are willing to take stock risk should begin with a diversified market portfolio. Each investor then can dial down total risk in the portfolio by adding fixed income to the mix. The greater the bond allocation relative to stocks, the less risky the portfolio and the lower the total expected return; the greater the stock allocation relative to bonds, the higher the portfolio’s expected return and risk.

Investors who want to take even more risk than the market can increase exposure through borrowing on margin and/or tilting the stock portfolio toward asset groups that offer higher expected returns for higher risk.

So, how does one confidently allocate between stocks and bonds?
A common method is to evaluate model portfolios along the risk-return spectrum. A riskier portfolio holds 100% stocks, and the least volatile portfolio holds 100% bonds. Between these extremes lie standard stock-bond allocations, such as 80%-20%, 60%-40%, 40%-60%, and 20%-80%.

Then you compare the average annualized return and volatility (standard deviation) of each model portfolio for different periods, such as one, three, five, ten, and twenty years. Volatility is one of several risk measures investors may want to consider. With this in mind, the analysis should feature average returns, as well as best- and worst-case returns for the various periods.

While this technique relies on historical performance that may not repeat in the future, and does not consider various investment costs, it may help you think about the risk-return tradeoff and visualize the range of potential outcomes based on the aggressiveness of your strategy.

Refining Your Stock Allocation
After establishing the basic stock-bond mix, investors turn their attention to refining the stock allocation, which is where the best opportunities to refine the risk-return tradeoff are found.* Investors who are comfortable with higher doses of equity risk can overweight or “tilt” their allocation toward riskier asset classes that have a history of offering average returns above the market. Research published by Eugene Fama and Kenneth French found that small cap stocks have had higher average returns than large cap stocks, and value stocks have had higher average returns than growth stocks. By holding a larger portion of small cap and value stocks in a portfolio, an investor increases the potential to earn higher returns for the additional risk taken.

The final step in refining the stock component is to diversify globally. By holding an array of equity asset classes across domestic and international markets, investors can reduce the impact of underperformance in a single market or region of the world. Although the markets may experience varying levels of return correlation, this diversification can further reduce volatility in a portfolio, which translates into higher compounded returns over time.

Fixed Income Strategies
Research shows that two risk factors—maturity and credit quality—account for most of the average return differences in diversified bond portfolios. Long-term bonds and lower-quality corporate bonds typically offer higher average yields to compensate investors for taking more risk. But keep in mind that these premiums are considerably lower than the market, size, and value premiums documented in the equity world.

Investors generally hold fixed income to either;
(1) reduce overall portfolio volatility, or
(2) generate a reliable income stream. These objectives typically lead to different investment decisions. The first approach, volatility reduction, is an application of separation theorem (i.e., hold equities for higher return and use fixed income to temper portfolio volatility). Rather than increasing risk to maximize yield, these investors want to hold fixed income securities that are lower risk. Certain fixed income asset groups are better suited for this strategy.

With this in mind, some long-term investors may seek to earn higher expected returns by shifting risk to the equity side of their portfolio. With an eye to minimize maturity and credit risk, they hold short-term, high-quality debt instruments that have historically offered lower yields with much lower volatility.

The second purpose for holding bonds is to generate reliable cash flow. Income-oriented investors, including retirees, pension plans, and endowments, may not worry as much about short-term volatility in their bond portfolio. Their priority is to meet a specific funding obligation in the future. Consequently, they design a portfolio around bonds and accept more volatility in hope of earning higher yields, which they pursue by holding bonds with longer maturities and/or lower credit quality.

Whether investing for total long-term return or for income, a portfolio should be diversified across issues and global markets to avoid uncompensated risk from specific issuers and to capture differences in yield curves around the world.

Summary
The stock-bond decision drives a large part of your portfolio’s long-term performance. During portfolio design, evaluating different stock-bond combinations can help you visualize the risk-return tradeoff as you consider the range of potential outcomes over time. Once you determine a mix, it can guide more detailed choices of asset classes to hold in the portfolio. And as your appetite for risk shifts over time, you can revisit the mix to estimate how shifting your portfolio mix may impact your wealth accumulation goals in the future.
 
One other thing to consider with corporate bond ETFs is the average maturity. Obviously with junk bonds in particular, the longer the time to maturity, the less likely the companies will be around to pay you that dividend. In general though, I think corporate bonds are undervalued at the moment, there are some great high yielding investment grade corporate bonds with quite low maturities, and the companies that comprise them are all flush with cash.
 
I'm thinking of investing approx 10% of my portfolio in this ETF. The rest of my portfolio is made up of three other equity ETFs plus four company stocks.

Any decision to invest in an asset class should be influenced by what other asset classes you hold. You say “The rest of my portfolio is made up of three other equity ETFs plus four company stocks.” So you are basically long equity. Corporate bonds, i.e. issued debt instruments, are liabilities to a company, as is owners’ equity. Owners’ equity, therefore, can always be increased by basically screwing bond holders, as a company’s assets must always equal its liabilities plus owners’ equity. As you are long equity you would have to ask why you would want to hold corporate bonds as there is always a risk a company can recall or redeem bonds to the disadvantage of the bondholder and to the advantage of owners’ equity. Management in aggregate can always increase the value of owners’ equity in aggregate by decreasing the value of issued debt in aggregate. So if you invest in the corporate bond fund, are you adequately compensated for this risk, along with the other risks of corporate bond investment? Government bonds do not represent this particular risk, so this is an asset class you might consider. [Disclaimer: The above is comment / observation and is not a recommendation to follow any particular investment strategy or to buy / not buy any particular fund or stock.]
 
Back
Top