Published August 29, 2013
Rising interest rates have, predictably, imperiled various corners of the bond market and scores of bond ETFs.
Soaring Treasury yields have prompted billions in outflows from ETFs that hold U.S. government debt, particularly longer duration fare.
Substantial outflows have been seen from U.S. high-yield bond funds and investment-grade corporate bond ETFs have offered little shelter from the storm. Emerging markets bond ETFs been trounced on tapering chatter and diminishing risk appetite in the fixed income space.
While all signs point to current environment being a tricky one to navigate for bond investors, some compelling opportunities remain among bond ETFs for those with an appetite for risk and a thirst for yield.
"While BBB and BB bonds are only one level apart in terms of credit rating, they have very different yield characteristics. For the 12 months ended July 2013, spreads above the five-year treasury yield ranged from 160 to 216 basis points (bps) for BBB rated bonds and ranged from 256 to 421 bps for BB rated bonds," according to S&P Global Fixed Income Research.
In a new research note, S&P Capital IQ points out that investors are demand higher yields to be involved with bonds that are rated at the higher end of the junk spectrum.
"The most common way for a bond to drop from investment grade to speculative, also known as becoming a falling angel, is to be downgraded one notch from BBB- to BB+. Through August 8 of this year, there were 17 U.S. companies that fell to speculative grade in Standard & Poor's Ratings, 13 of them have fallen one notch. Meanwhile, in the other four instances, the credit ratings fell multiple notches," said S&P Capital IQ in the note.
Investors can access fallen angel bonds with the Market Vectors Fallen Angel High Yield Bond ETF (ANGL). Nearly two-thirds of ANGL's holdings are rated BB and over 48 percent of the fund has maturities ranging from one to five years.
Fallen angel bonds offer some benefits to investors that are often overlooked. First, these bonds have better credit profiles than traditional junk bonds because fallen angels once had investment-grade ratings. As such, fallen angels have lower default and offer the potential for robust capital appreciation because they earn promotions back to investment-grade status more often than bonds that were born as junk. ANGL has a 30-day SEC yield of 5.14 percent.
Another option for investors looking to explore bonds with "B" ratings is the iShares Baa - Ba Rated Corporate Bond ETF (QLTB). Over 64 percent of QLTB's 372 holdings are rated BBB+, BBB or BBB-, so this is not a pure junk bond ETF. That is reflected in the 12-month trailing yield of 3.61 percent, 286 basis points below that of the iShares iBoxx $ High Yield Corporate Bond ETF (HYG), the largest junk bond ETF.
QLTB, which was rated Marketweight by S&P Capital IQ, has an effective duration of 6.19 years and annual fees of 0.3 percent. Top-10 holdings include issues from Ford (F), Citigroup (C) and American International Group (AIG).
The SPDR BofA Merrill Lynch Crossover Corporate Bond ETF (XOVR) also goes overlooked for the simple reason that some investors do not know exactly what a crossover bond is.
"Crossover" corporate debt generally means corporate debt rated at levels where the lower end of investment grade debt and the higher end of high yield debt meet. Qualifying securities must be rated BBB1 through BB3, inclusive (based on an average of Moody's, S&P and Fitch). Qualifying securities must have at least one year remaining term to maturity, a fixed coupon schedule and a minimum amount outstanding of $250 million," according to State Street.
XOVR, also rated Marketweight by S&P Capital IQ, has lost 5.7 percent since May 22 when Federal Reserve tapering chatter started in earnest. The fund's modified adjusted duration is almost 5.6 years, which is well below that of the largest investment-grade corporate bond ETF. XOVR's current yield is 5.3 percent with an average yield to worst of 4.36 percent. Yield to worst is a measure of the lowest possible yield an investor can garner without the issuer defaulting.
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Disclosure: Author owns none of the securities mentioned here.
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