Going High Class With A Junk Bond ETF

As the name and the credit ratings imply, junk bonds are not the five-star hotels of the fixed income universe. It is the high yields that lure investors to junk bonds and exchange traded funds, such as the iShares iBoxx $ High Yid Corp Bond (ETF) (NYSE: HYG) and the SPDR Barclays Capital High Yield Bnd ETF (NYSE: JNK).

'Junk' Doesn't Mean Unworthy Of Consideration

However, in a year in which energy issuers are once again challenged and CCC-rated (or lower) debt has become increasingly risky, investors should consider examining the upper crust of the junk bond ETF universe. That segment includes the PowerShares High Yield Corporate Bond Portfolio (NYSE: PHB).

As was recently noted in highlighting PHB, for much of this year, advisors and investors have heard about the astronomical growth of strategic beta ETFs, and when more bond funds are likely to embrace such a methodology.

Consider PHB the forefather of smart beta bond ETFs because the fund tracks the fundamentally-weighted RAFI Bonds US High Yield 1-10 Index.

Looking Into PHB

One PHB's primary advantages at a time of elevated high-yield energy defaults and when it appears clear the Federal Reserve will soon raise interest rates is that the ETF excludes CCC-rated debt.

“As such, this fund may fit the bill for investors looking for a less aggressive high-yield option. However, a potential drawback of the fund's higher-turnover strategy, which tilts away from the largest issuers, is that higher transaction costs may lead to greater tracking error, as has been the case historically,” said Morningstar in a recent note.

PHB's underlying index "invests in only credits rated B3 and above by Moody's and B- and above by S&P. That means investors are exposed to the higher-quality segment of the high yield market. These are bonds viewed as having less default risk that have the potential to outperform during periods of volatility and widening credit spreads – the very conditions we’ve witnessed in recent months. (Of course, there are other times when lower-rated credits will outperform.)," said PowerShares in a recent research note.

“Tactical investors may look to a fund like PHB as a way to bolster income in a yield-starved environment. However, the current yield is compensation for credit risk and should be viewed in relation to the yield offered by U.S. Treasuries with the same maturity. The difference between the two is known as the credit spread, and it represents the premium investors can collect for assuming the additional credit risk. Remember that since PHB excludes issuers rated below B, it will have a slightly lower risk premium than its peers that cover the entire high-yield market,” added Morningstar.

PHB's lower risk profile results in a lower yield. HYG and JNK have an average 30-day SEC yield of 6.8 percent, but PHB's 30-day SEC yield is just under 5.1 percent.