Why rallying rates are bullish for high-yield bond ETFs

Market Realist

With the taper pushed off until 2014, bond funds might be a good intermediate play

Weak economic data since the end of the government shutdown has led the market to price out the likelihood of the Federal Reserve tapering asset purchases in 2013. We can see this effect in the yield of the ten-year Treasury bond. Between May and September, investors increasingly expected the Federal Reserve to reduce its quantitative easing program. The ten-year yield rose from 1.63% to 2.96% during this time, as the market priced in higher short-term rates in the future.

The calmer outlook for interest rates makes high yield credit funds a potentially attractive investment. Bond funds benefit from falling interest rates due to the inverse relationship between interest rates and bond prices. We can see this in the price performance of several bond funds over the last six months.

The Fed wants unemployment to fall below 7%, and analysts expect it to continue easing until the economy is closer to that objective. That means interest rates are likely to stay at or below current levels, benefitting high yield bonds.

Interest rates are still historically low, so investing in bonds is risky long-term

Interest rates have been in a secular (long-term) decline since the early 1980s. Nominal rates can’t go below 0%, so there’s a firm floor to the upside potential to bonds. Long-term mean reversion in interest rates is a huge risk to holding bonds in this environment. Bonds do pay interest, however, and the large “carry” of high yield debt means that investors are compensated to take on interest rate risk.

Investors interested in high yield credit have several options, including the iShares High Yield Bond ETF (HYG) and the SPDR High Yield Bond ETF (JNK). Bank loans are similar to high yield bonds and are accessible through the PowerShares Senior Loan ETF (BKLN).

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