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SPDR Barclays Capital High Yield Bond Message Board

  • jagrantjr jagrantjr Feb 18, 2010 10:21 AM Flag

    Effects of Changing Interest Rates on JNK?

    So let me start this by saying I'm new at investing in bond ETFs. I'm a conservative (read: safe) investor, so buying this ETF was quite a stretch for me. But... like many people, I needed to replace lost interest income somehow.

    I bought shares in JNK because of the high yield (to replace expiring CDs from a couple years ago). I have been happy with the return I've made so far in dividends, however in the short time I've been in JNK, the share price hasn't really moved much either up or down. I'm ok with that, I just like the dividends in my account each month.

    But now I've reached the limit of my understanding of changing interest rates on bond ETFs.

    It appears the Fed is laying groundwork to raise interest rates sometime in the next year.

    How will these interest rate increases affect the share price of JNK? And the yield of JNK?

    An investment newsletter that I read often recently recommended pulling back from corporate bonds and moving into government bonds. This makes sense to me if the Fed follows through on raising rates and CDs begin to pay again. I don't really want to be in JNK any longer than I have to be, so my thinking is that if rising interest rates will lower the share price and/or yield of JNK, then my plan would be to pull back now while I still have all my principal and move to a government bond investment (ETF or mutual fund) until rates on CDs move back up. Then I'd get back into CDs and sleep a little easier each night.

    I'm interested to hear from folks who know and understand this market a whole lot better than I do.

    Thanks.

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    • Here is a comparison between the ten year bond interest rates and vanguard high yield bond fund:

      http://stockcharts.com/charts/performance/perf.html?$TNX,VWEHX,$irx

      JNK does have enough history buy JNK should have a high degree of correlation with VWEHX.

      As you can see high yield bonds do not track interest rates as much as they track credit quality.

      IRX -> 90 day treasury
      TNX -> 10 year
      VWEHX -> proxy for jnk with some long term data.

    • Saw that today. Rather timely, I thought.

    • Interest rates and bond prices move in opposite directions. So when the Fed moves to raise interest rates via open market operations, that will tend to decrease bond prices in all sectors be they government or corporate.

      Now, how much bond prices move is a concept known as duration. It's slight complicated to figure out exactly but for our purposes keep in mind this concept: Duration is affected by the two L's. The Longer a bond has until maturity and the Lower it's coupon payment the more it will be affected by interest rates. High yield bonds have high coupon payments (the "high" in high yield) so they're less sensitive to interest rate movements than bonds with the same maturity that pay a lower coupon rate.

      Morningstar has also provided this risk graph http://finance.yahoo.com/q/pr?s=JNK which shows JNK has a "medium" (whatever that means) sensitivity to interest rate movements.

      So the upshot to all of this? An rise in interest rates will decrease the price of bonds but less so for high yield bonds. This will be slight bearish for JNK.

      • 1 Reply to atlas4292000
      • OK, so now we're getting somewhere.

        When interest rates rise, bond prices decline.

        That tells me that when the Fed eventually gets around to raising rates this year, the prices of the underlying bonds in JNK will decrease, and this in turn should decrease the ETF share price, although this reaction may be more muted for high yield bonds than for other bonds, as pointed out above.

        A lower price on JNK must increase the yield (right?), so if we're heading into a period of incremental increases in rates (say the reverse of the decreases in '08, where they went down in rapid intervals but with small changes), then the short term strategy for JNK this year would be to sit on the sidelines until rates stabilize or possibly to play the trade around the dividend date (I've noticed that going on, but it's not 100% consistent every dividend).

        But I'm not really a trader. Don't have the time to really be able to do that. Too much going on with job, kids, community, etc.

        So I'm thinking then that I should sell portions of my holdings in JNK into something more stable (but what?) over the next few months, then wait for rates to stabilize on the up side. Once there, possibly get back in to JNK in dribs and drabs as part of a more balanced bond portfolio.

        Does this sound sensible?

        Thanks for the insightful replies.

    • It might help if you think of JNK moving like the stock market. The movement of JNK is very closely correlated to stocks. What is good for stocks is good for JNK. However, JNK is not as risky as stocks. It will not go down as much as stocks and will not go up as much either. Think of your return as being the 10% - 12% interest every year. Reinvest a little of your interest every year and grow your capital some. Don't try to time the market. Just buy and hold. This is one way to look at it. Hope it helps.

      • 1 Reply to tomcypert
      • Agreed. I am just glad I first bought into JNK in March of last year. Have added some more twice since then, including last week. Whenever it gets below the target allocation percentage in my portfolio is when I add more (that is if another component is not even further below its target allocation), using a "rebalancing with new money" strategy.

    • In a rising interest rate environment you are certainly safer in JNK then Gov bonds. You want to be long Gov bonds in a declining or weak economy. The fed isn't going to be jacking up rates in a weakening economy. In my opinion, the time for government bonds is past. What high yield bonds needs to succeed is a robust economy more than an acommodative fed.
      If you are a typical low risk bond investor you should be mainly be in well rated coporates now and use only small amout of JNK for a little kick but not a substatial part of your bond portfolio.

    • I will take a 10% -12% MONTHLY dividend any day! As long as you have a STOP LOSS on JNK (and everything else, I might add!), you'll be o.k. even if it drops like a rock. Also, to be honest, I don't really care about the PRICE of the ETF...just the dividend payment each month. JNK has been very very good to me!!!

    • First, I’m not sure I’m any wiser than you, but I’ll give your request a try.

      Second, although there is some logic and history in this post never forget that Ms Market can do anything she wants, and she will.

      Third, your post discussed corporate bonds and treasuries. I don’t regard JNK as either, I think JNK is junk bonds as opposed to higher rated corporates. When people say “corporates” I think of investment grade corporate bonds or investment grade bond funds.

      Finally: When interest rates rise it means that some money will flow to the investments that are now yielding higher returns. That’s not going to happen much w the discount rate change because there aren’t a lot of bank funds tied to the discount rate. In principle I’d expect no effect, or a small effect, on JNK; however, the market may panic and JNK may get dragged along with it.

      Then there will be the cases where the FMOC raises short term rates - and that’s going to happen at some point in our future. As the Fed increases short term rates banks will increase short term rates on demand deposits, CDs, etc - so money will flow from say bonds back to those insured investments. It’s a competition for funds thing. The bonds and bond funds that will get hit first and hardest will be those that pay nearly what the new rate is (i.e. low yielding bonds & bond funds) even though they are better investments (i.e. higher rated) than junk, because the INSURED yields from banks will be more attractive than the relatively secure but relatively low yielding “investment grade” bonds. People will not be interested in buying low yielding bonds or bond funds, so their prices will drop. So low yielding bonds will be most affected by increases in the Fed rates. High yielding bonds will also be affected, but not as much, because there is still a big incentive to stay in them - they will still have much higher yields. Also, when the Fed raises rates it means that business conditions are improving, which should translate to lower bond defaults, which is good for junk bonds - defaults are an issue for junk bonds but not as much an issue for higher grade corporate bonds.

      Bottom line: I expect JNK to be affected by rate increases, but affected less than other bond categories. I do NOT think treasuries are a good idea. Yields on treasuries are at historic lows and have nowhere to go but up, which means their price will decline (their coupon is fixed, if the rate on a bond increases the price has to decline). If I were very worried about losing money in the transition (i.e. as the Fed hikes rates) I might go to cash and just wait for things to settle down. But personally, I think JNK will do OK, if you are in it for the divys. If you are in JNK for it’s price, the price may gyrate around significantly, dunno, and you might (or might not) be better in cash.

      Take a real world case: Today you might get 1% on a CD, but JNK yields 12% - you want the yield so you went with JNK. Suppose the Fed FMOC doubles it’s rate to 2%, which is a big jump, now your choice is 2% in a CD or 12% with JNK - what will you do? A lot of people will stay with JNK even though the Fed rate has doubled. JNK is risker, but you are being paid to take that risk. Finally, suppose Paul Volcker was in charge of the Fed and they raised interest rates to say 10% - i.e. you could get an insured CD that yielded 10%; would you stay in JNK at 12% vs an insured CD at 10% - you might get out of JNK and go for the insured CD. My point is, you have to be paid to take the incremental risk of holding JNK vs an insured CD, but with a 10+% yield differential you are being well paid. Disclosure: I’m holding JNK.

      • 6 Replies to dclewis12002
      • Great wishful thinking. I'm 1/3 invested in junk bond CEF, namely PHT, which steered clear of financials, still a bubble investment--JNK MUST by definition contain losers--I'd rather vette each investment--and PHT wins handsown at 11% return only from investment cash flow 8 years, NOT return of capital.

        NONETHELESS, Bernookie pops irates a simple 1/4, the market will discount the other 4.25% immediately, and down we go the other side of the W.

        Junk included.

      • Actually I would expect JNK to increase in price if the economy continues to improve, which would be the likely cause of interest rates going up. More than half of the yield on the underlying bonds can be thought of as a risk premium. You are paid a high interest rate because there is a significant chance that the companies backing the bonds will default. However, if the economy improves it follows that companies backing these bonds will perform better and there will be less default risk. Thus the default premium will go down (i.e., bonds will pay a lower interest rate). Since bonds pay a fixed level of interest, a lower interest rate corresponds to a higher price for the bonds. Another way of saying this is that if the economy improves junk bonds will become less junky and they will pay interests rates closer to treasury. I think the real risk of holding this fund is that if the economy tanks, so will this fund. So this is really a bet on the economy. Good prospects for the economy translates to good performance for JNK. Of course if economy stays level or worse and treasury rates rise, this would be really bad for JNK. Of course under such a scenario, all bets are off on any investment.

      • Nice reply, I like your train of thought dclewis, one thing at the end, if a CD was equal to 10% I would think JNK rates would rise beyond 12% eventually as well.

      • Generally, I agree with the points you made. It's very difficult to estimate/predict future valuations of these JNK bonds, given all the variables you mentioned. Because of the fluctuation in JNK's over these two years (from $45 down to $25, and then back up to $40 or so), I do think you need to consider total return (div + price) on this investment. I can imagine some investors really got burned during the first year of JNK's inception.

        I think most would conclude that JNK's price in the Fall of 08 and the Spring of 09 were outliers (as was much of the market), but JNK is still relatively volatile for a bond fund, even after factoring out the two outlier periods I mentioned. Because of this volatility, I've traded in/out of JNK more than I anticipated. A 12% annual div paid out monthly sure is tempting, I have to admit, but I'm unwilling to give up much if any principal in pursuing this little pot of gold at the end of each month. And like many of you investors, I'm nervous over whether the good times in price and div payments will continue to roll.

        Lately (last 6 months or so), I've been buying in a week or so after ex-div, and then selling a few days b/f the next ex-div, if I see the JNK price starting to drift down. If JNK holds up in price, I'll hold on for a div. This "strategy" might seem odd (foolish?), but I seem to be doing a little better that just holding on through each ex-div. Some buyers want to get in just b/f the div, and some seem to sell just after the div (there's also some arbitrage going on I realize). I just don't see how they're really making much with that approach. It seems better to do the reverse as I've done (buy after ex-div, and sell just before ex/div).

        If one intends to trade like this, you might also wonder why not just buy/sell stocks instead. But of course stocks don't pay monthly div's, so it doesn't work as well. I should mention that I buy 1k lots, and never hold more than 3k at a time. I suppose another way to look at this is why tie up $120k in funds for an entire 30 day period when pay-day (ex div) only occurs on one of those days each month, and you earn the full div regardless of whether you held JNK the entire 30 days or just the one day (ex-div day).

        Btw, I'm holding this in a 401k so I'm loath to loose principal and don't especially care whether I make it in div or cap gains. I looked into buying options as a hedge, and then just hold JNK, but I think the premiums are a bit too high on the put side (6-7% for Jun 10 $38 strike).

        So for me, I will trade in/out if I think I can do as well or better than the normal div and be sufficiently agile to avoid any downdrafts

      • That is what I was thinking. Corporate and Junk bonds, especially those with a longer time to maturity, would be less affected by the short rates than the short term treasuries.

        In fact, the longer term bonds may be helped by this short term interest rate increase. Longer term bond rates and prices are influenced by anticipated inflation in the future. Higher short rates makes the US$ strengthen and is seen as a way to fight future inflation, so that may be why JNK is up today, along with general bullishness in the market.

        I first bought JNK in March of last year. Got it cheap. Yield is down from there, but the dollar payout has not decreased by any significant amount. The strengthening economic situation may mean that the debtors on the bonds that make up JNK may be in a better position to keep up payments.

      • Were up today with the Fed rate increase yesterday..Maybe it has to due with Bond ratings getting better as the economy digs out??

    • As far as I understand it, the interest rate for corporate bonds depends primarily on the credit rating of the corporation. The fed rate is only a small portion of this currently. For example, if the fed raises rates from 0.25% to 0.5%, a company that would have to pay 8.25% for a loan will have to pay 8.5% in the future. That's something like a 3% difference. It will have an effect of existing bond prices, but it won't be as dramatic as for lower yielding bonds.

    • Hard to say but remember one thing about Junk Funds... when panic sets in they drop like a rock so be sure to set a stop. They creep up slow but they drop like a rock when the plug is pulled. All I am saying is check it everyday.. this is not a fund to buy and forget.

 
JNK
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