Forget Blue Chips: This 7% Yield Could Be Safer Than You Think

Blue chips aren’t known for cranking out big market-beating gains. But that’s exactly what has happened in the first nine months of 2012, with the group surging higher as investors fled volatility and slow economic growth in favor of yield and stability.

But these big gains are now proving to carry unintended consequences. After many leading blue chips traded well into all-time highs and unusually high valuations in the past six months, all of a sudden these bastions of safety aren’t looking so safe anymore.

Take Wal-Mart (NYSE: WMT) for example. The company’s stable revenue growth and dividend yield of 2.5% drove huge capital inflows in 2012, lifting shares to a new all-time high and an unusually lofty valuation. But during the weak market of the past month, Wal-Mart shares have fallen sharply, down 11% against the S&P 500’s 7% decline. The story looks much the same for other leading blue chips, with Intel Corp. (Nasdaq: INTC) down 14%, Caterpillar Inc. (NYSE: CAT) down 11% and International Business Machines (NYSE: IBM) down 11% in the past two months. 

Take a look at that weakness below.

These blue chips are supposed to help investors stay defensive. But after posting outsized gains early in the year, they have been under pressure. With valuations and prices remaining relatively high, this weakness trend is well in play right now.

That’s why I am such a huge fan of iShares iBoxx High Yield Corporate Bond (NYSE: HYG), an exchange-traded fund (ETF) that corresponds to the performance of the iBoxx $ Liquid High-Yield Index. Although categorically this is an investment in “junk bonds,” there are more than few reasons why this ETF is an excellent alternative to blue chips.

The first is its amazing dividend yield. Clocking in at an eye-popping 6.8%, this impressive stream of income is almost three times the size of blue chips such as Wal-Mart, IBM and Intel.

HYG also provides plenty of stability for investors looking to avoid the volatility of the equity markets, including large-cap, blue-chip stocks. That price stability is being driven by lower default rates in the high-yield space. These default rates have fallen from 13.3% in 2009 to 3.3% in 2010 and to an even lower 2.2% in 2011. With corporate profits, margins and cash balances at record highs, the private sector’s strong financial profile is giving investors more than a few reasons to avoid the low returns of Treasurys and the tattered balance sheet of the federal government.

And that strong price stability has been on display in the past month, with HYG handily outperforming the market, falling just 1.5% against the S&P 500’s 5.2% decline. Take a look at the chart below.

Beyond yield and stability, HYG average daily volume of almost 5 million shares provides plenty of liquidity for individual and institutional investors looking to initiate larger positions. A tight bid-ask spread also enables investors to reduce price slippage.#-ad_banner-#

In terms of fees, HYG’s expense ratio of 0.5% is directly in line with its category average, but still less than most actively managed high-yield bond funds.

The combination of liquidity, spreads and an attractive expense ratio has fueled investor interest in the HYG, pushing total assets under management to just a pinch shy of $16 billion, making it one of the most popular high-yield funds in the market.

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 increases the probability and volume of credit events.

Action to Take –> High-yield bonds are a great alternative to general equity exposure, particularly to large-cap blue chips that pay a dividend. Not only does HYG’s high-yield of almost 7% crush any dividend in the Dow, but prices are proving to be more stable. All in all, this fund is an attractive combination of yield and stability in an era of anemic interest rates.

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