Forget The Fed: Earn An Extra 8% From 2013's #1 Bond Investment

StreetAuthority Network

For as good as 2013 was for stocks, it was equally bad for bonds.

Bonds posted their lowest return since 1994. Investment-grade bonds posted their lowest return since 1980 and first loss since 1999. Last year was the only third year in the past 34 that bonds closed the year with a loss.

This bout of weakness was driven by the Federal Reserve, which in May announced its intention to taper its quantitative easing stimulus program. That sent many investors fleeing bonds trying to avoid rising rates. 

But that would be a mistake. One group of bonds is in position to continue bucking that bearish trend -- and deliver more than double the yield of the 10-year Treasury.

While most classes of bonds were suffering sharp losses last year, there was one group that was virtually immune from that weakness. In fact, these bonds actually finished the year in the green, making them the top-performing class of bonds in 2013. 

While the iShares 20+ Year Treasury Bond (NYSE: TLT) has fallen nearly 10% in the past 12 months and iShares iBoxx Investment Grade Corp Bond (NYSE: LQD) is down almost 1%, the iShares iBoxx High-Yield Corporate Bond (NYSE: HYG) has gained better than 5%:

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That divergence pattern has left many investors scratching their heads. Why are "junk bonds" performing so well in a weak bond market?

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The answer is interest rate sensitivity.

High-yield bonds are issued by companies with lower credit scores and more leverage in the balance sheet. That is an important distinction because it makes junk bonds less sensitive to interest rates and more sensitive to underlying economic growth. The concept is simple: As long as the economy grows, leveraged companies will have the earnings and cash flows to service their debt.

That's why high-yield bonds posted a great year in 2013. The U.S. economy grew 1.9%, and the global economy grew 3%. That supported debt service for leveraged borrowers and lifted high-yield bonds to a strong outperformance.

And that's exactly what's on tap for 2014. The International Monetary Fund (IMF) recently increased its 2014 growth projections to 3.7% for the world economy in 2014 and 2.8% for the U.S.

Here's something else to consider. The private sector has never been stronger. Earnings, cash balances and margins are all at all-time highs. Even companies with lower credit scores are as financially strong as they've ever been. That means it's a great time to own high-yield corporate bonds.

Both are bullish signals. Because with investors desperately searching for yield in a low-yield market, high-yield bonds cannot be ignored.

The iShares High-Yield Bond is an exchange-traded fund (ETF) that is linked to a high-yield bond index. One of the most popular ETFs (particularly among bond funds), HYG ranks as one of the top 50 ETFs, with assets under management of $15 billion.

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HYG is a great fund for diversified exposure to high-yield bonds. Being linked to an index has the fund holding 884 high-yield corporate bonds. Its top 10 holdings account for just 3.9% of total fund assets, adding further diversification.

HYG is a junk-bond ETF, but it is hardly made up of no-name companies with little brand recognition or financial strength. Its top 25 holdings are loaded with familiar names, including Sprint Nextel (NYSE: S), Icahn Enterprises (Nasdaq: IEP), Tenet Healthcare (NYSE: THC) and Citigroup (NYSE: C). These are companies with strong operating histories that benefit from high barriers to entrance. That supports consistent debt service.

Investors are well compensated for accepting the extra credit risk that high-yield bonds carry. HYG is currently yielding 6.2%, more than twice the 2.9% yield on the 10-year Treasury.

HYG also scores well on expenses. Its expense ratio of 0.50% is in line with its category average of 0.48%.

The Options Trade Setup
Options are most commonly associated with stocks. But with ETFs offering access to a wide range of markets, options offer another strategy to cash in.

As an asset class, bonds (fixed-income) is less volatile than stocks. And because volatility is the most important factor when trading options, we will need to adjust our parameters accordingly.

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Most of the time when I sell puts, I use strike prices that are 10% to 15% out of the money. That's a conservative threshold that reduces the probability of actually being put shares.

But because bonds are generally less volatile than stocks, I am going to adjust my strike closer to the money. That will increase the size of the premium I collect while still carrying a low probability of being put shares.

I'm also going to push my expiration to the long end of my target range between 45 and 60 days. Selling March puts instead of February puts increases my premium payment to $35 instead of just $10. Taking a longer-dated expiration also increases the probability of being put shares, but since I'm bullish on high-high bonds and HYG, I'm confident prices will continues to advance in the next few months as the economy accelerates into 2014.

Action to Take -- > Being put 100 shares of HYG at a strike price of $90 would require a $9,000 investment. But to initiate this trade, I won't need the full amount. Most brokerage firms require a 20% deposit to control the position. That puts my margin deposit for the HYG trade at $1,800. Here's how the trade looks if the options expire worthless. As you can see, this is a high-probability trade, with a 98% chance of our options expiring worthless. A potential 1.1% return in 60 days compounds out to a potential 8% gain in 12 months, without buying a single share of HYG.

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Here's how the trade looks if we are put shares:

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