If you believe in contrarian investing, take a look at high yield bond funds. The beaten-up sector offers the best opportunities right now for income-oriented investors, according to Joshua Rank, manager of the NEI Northwest Specialty Global High Yield Bond Fund.
The values of high-yield bonds have been hammered this year by investors concerned about a pending increase in American interest rates. The sell-off – Mr. Rank calls it a "buyers' strike" – has propelled yields sharply higher. At the time of writing, the yield on the Barclay's U.S. High Yield Index was at 8.2 per cent, representing the widest spread against government bonds in years.
"High yield bonds offer the best overall opportunities right now," Mr. Rank, who works for Principal Global Investors LLC in Des Moines, Iowa, said in an interview. "They represent good value at this level."
Income investors are faced with what he terms a "depressed yield environment" right now. In this situation, they have only four viable options.
Buy longer duration. Although the technical definition of "duration" is much more complex, this essentially means buying bonds or bond funds with longer maturities to take advantage of the higher yields they offer. The trade-off is greater risk and volatility. Bonds or bond funds with long durations are more sensitive to interest rate changes than short-term ones. For example, the iShares Canadian Short Term Bond Index ETF (XSB-T) has a duration of 2.81 years (low risk) and a distribution yield of 2.44 per cent; the iShares Canadian Universe Bond Index ETF (XBB-T) is 7.26 years (medium risk) with a 2.82 per cent yield; while the iShares Core Long Term Bond Index ETF (XLB-T) has a duration of 14.23 years (high risk) and a yield of 3.6 per cent. (All figures as of Oct. 16.) As long as interest rates are neutral or declining, long duration funds will outperform. But when rates rise, watch out.
Move down the quality curve. The higher the quality of a fixed income security (bond, preferred share, etc.) the lower the yield. That's why a Government of Canada bond will pay less than one issued by a municipality and much less than high-yield bonds (sometimes derogatorily referred to as junk bonds). A bond's credit rating will tell you all you need to know. Canada bonds are rated AAA (the best you can get). Any bond rated B or below should be considered risky, but it will offer a much better yield to compensate.
Switch to equities. Many dividend stocks offer higher yields than quality bonds these days, including issues from the big banks and major utilities. The trade-off is exposure to stock market risk. When the broad market falls, it takes all the ships down with it, regardless of their quality. That's what happened in 2008 when the TSX financial sector lost more than 38 per cent. All the big banks and insurance companies survived but it was a gut-wrenching time for investors.
Accept lower returns. If you can't handle the risk involved in the first three options, then you have to accept the reality of depressed returns for as long as interest rates remain low. It's the old axiom of investing: the higher the potential return, the greater the implied risk.
So what is the downside risk at this point of a high yield bond fund such as the one managed by Mr. Rank? He and his team calculate it to be 2.65 per cent, which is quite acceptable. The total return upside potential over the next 12 months is in the 10-per-cent range while the mid-range (and most likely) forecast calls for a 7 per cent profit.
High-yield bond funds have a tendency to rebound strongly after off years. This fund, for example, lost 26.4 per cent during the financial crisis of 2008 but then recovered with a 39.9-per-cent gain in 2009. It also recorded double-digit advances in 2010 (12.2 per cent) and 2012 (13.6 per cent). As of Oct. 16 it was off about 1 per cent year-to-date.
This is not the best high-yield bond fund around but in recent years it has ranked in the top quartile of its category, according to Morningstar. The five-year average annual compound rate of return to Sept. 30 was 4.7 per cent. The fund invests primarily in corporate bonds from North America and Western Europe; there is no emerging markets or sovereign debt.
Distributions are paid monthly but can vary considerably. The MER is on the high side for a bond fund at 2.22 per cent.
Ask your financial adviser if high-yield bonds are a suitable choice for your account.
Gordon Pape is Editor and Publisher of the Internet Wealth Builder and Income Investor newsletters.