This Bond ETF Yields More Than Treasuries. Is the Extra Income Worth the Risk?
Key Points
The iShares iBoxx $ High Yield Corporate Bond ETF currently yields about 2% more than intermediate-term Treasuries.
As long as the U.S. economy remains in reasonably good shape, junk bonds and their higher yields look like a better option.
Junk bonds have lower credit quality than Treasuries but less interest rate sensitivity.
Treasury bonds are offering some of their most attractive yields in years.
The 30-year bond, for instance, recently hit 5.3%, its highest level since 2007. But that yield comes with caveats. It's been moving higher because of concerns about rising debt, deficits, and inflation. Those problems are unlikely to be solved anytime soon.
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That's why I believe the iShares iBoxx $ High Yield Corporate Bond ETF (NYSEMKT: HYG) is interesting here with its current yield of 6.5%. It invests in junk bonds, but the health of corporate balance sheets is good enough right now that the risk of investing might be below average.
But credit quality isn't the only consideration.
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What the 6.5% yield buys you
The iShares iBoxx $ High Yield Corporate Bond ETF invests in more than 1,300 different securities, virtually eliminating the risk of any one default materially impacting the portfolio.
Overall, the fund has around 57% of assets in BB-rated bonds, the highest rating in the junk bond category, and another 32% in B-rated bonds. Another 7% is invested in CCC-rated securities. That's a fairly typical risk profile for a junk bond ETF, but it does mean potential volatility because the quality of the underlying bonds is in question.
On the positive side, the fund's duration, which is a measure of interest rate sensitivity, is relatively low. If interest rates start to rise as they have been in the Treasury market, this ETF may be somewhat shielded from the negative impact.
We can use the iShares 7-10 Year Treasury Bond ETF as a proxy for the intermediate-term government bond market. It comes with very high quality but a duration more than double that of HYG.
In other words, Treasuries have low credit risk but higher interest rate sensitivity. This junk bond ETF has higher credit risk but lower interest rate sensitivity.
Is HYG worth the extra risk?
Looking purely at share price volatility, these two ETFs have very similar levels of risk. But the junk bond ETF has a yield premium of roughly 2%.
Based on that, HYG has the advantage, but it may ultimately come down to where you think the U.S. economy is headed.
If we see a significant slowdown or even a recession, Treasuries could benefit from a flight-to-safety trade. In that scenario, it wouldn't be surprising to see Treasuries rise in value while junk bonds decline significantly.
In more normal conditions, junk bonds have a better chance of outperforming because the credit quality difference is less of a concern and investors can grab the higher yield for only a modest amount of increased risk.
In today's environment, I think the iShares iBoxx $ High Yield Corporate Bond ETF has a clear advantage, but be careful if the economy shows signs of a sharper slowdown.
David Dierking has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.