Why 2010 is THE Year for This Investment

A year ago, high-yield bonds were outcasts. The financial world braced for Armageddon, and investors fled riskier high-yield bonds in droves in anticipation of widespread defaults. Yield spreads — in this case, the difference between yields on high-yield bonds and yields on “AAA”-rated corporate bonds — soared to a record high of 14% in the beginning of April.

What a difference a year makes.

As panic from the financial crisis waned, investors came back to high-yield offerings. As a result, the Merrill Lynch High Yield Master II Index (a sector benchmark) soared +52.7% in the first nine months of 2009, and the yield spread came down to 5.8% as of mid-December.

Doesn’t this mean the party is over?

History says no. While this past year’s returns are unlikely to be repeated, there are several reasons to believe solid returns are still to be had in high-yield bonds. While the spread has moved down to 5.8%, that’s still 2% above its average during the past 21 years, meaning there’s room for further gains.

If you look at the aftermath of bear markets for high-yield bonds, the bonds experienced several years of strong performance, not just one good year. After the sell-off in high-yield bonds in 1990, the sector outperformed the broader Barclays Capital Aggregate Bond Index through 1997. Likewise, after a bear market for the high-yield bonds in 2002 they outperformed higher-quality bonds through 2006.

But aren’t high-yield bonds inherently risky? Sure, there is more risk than with higher-grade bonds, but there is also more reward. The good news is that the corporate default rate (a major barometer for measuring risk in the high-yield market) appears to have peaked. Rising default rates add risk to high-yield bonds and generally cause a sell-off in price. However, the reverse is also true — falling defaults increase investors’ risk tolerance and normally lead to higher returns.

As the economy fell into recession, earnings were lower and more companies had trouble making debt payments. In addition, tighter credit markets made it difficult for companies to refinance their obligations. According to Moody’s, the U.S. high-yield corporate default rate peaked in November at 13.8%, the highest since 1991.

But in April, Standard & Poor’s had predicted corporate default rates would peak at 14.3% by March 2010. As economic conditions have improved, this forecast has changed dramatically. Standard & Poor’s forecasted in October that the default rate will average just 6.9% by September 2010, citing improved credit markets and a better economy. As well, Moody’s has predicted the default rate to fall to just 4.5%.

In short, everything seems to be lining up for the high-yield bond sector in 2010. An improving economy is lowering default rates. Spreads are still at historically high levels. And, historically high-yield bonds have been attractive at this point in the market cycle.

How can you invest in this high yield opportunity?

There’s no doubt one of the best ways is through a fund. The diversification of funds (which usually hold dozens or hundreds of bonds) greatly reduces the risk inherent in owning just a handful of high-yield bonds. Funds also usually provide the convenience and cash flow advantage of monthly income.

With just a quick screen, I’ve uncovered about 200 different high-yield bond funds with distribution rates as high as 11%, 12%, or even over 13%. But how can you select which ones to own?

Before diving deeper, I like to look at a fund’s performance relative to its index and other funds. Performance is like a fund’s resume, and you can find ones that have consistently performed well. Leverage is also an important consideration. When a fund uses leverage, it borrows short-term money at low rates and uses those borrowings to invest in higher-paying bonds. However, if short-term rates rise, it could reduce the spread the fund earns and put pressure on its distribution and price.

With these items, in mind, I’ve started looking at the iShares iBoxx High Yield Corporate Bond ETF (NYSE: HYG). This unleveraged fund has only been around for a couple of years, but its performance has matched up well with its index.

In 2009 the ETF participated in the high-yield bond bull market, returning +28.5%. Moreover, its 290 holdings — and 9.3% yield — could make this one of the most attractive ways to profit from the opportunity in high-yield bonds.

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