Think Stocks Are Hot? Check Out High Yield Bond Returns!
U.S. Investors are celebrating this week as the Dow and S&P 500 indices both hit new all-time highs. What most investors don’t realize is that high yield bond returns are are even better!
On Wednesday, the SPDR DJ Industrial Average (DIA) closed at $183.60. (DIA is an ETF that tracks the movement of the Dow Jones Industrial Average.) This is 5.5% higher than DIA’s price at the beginning of the year.
Add in dividends and investors in DIA are sitting on a total return of 6.8%.
Not a bad return, especially when considering how far the market dropped during the first two weeks in January.
But compared to high yield bond returns, the Dow falls short.
On Wednesday, the iShares High Yield Bond ETF (HYG) closed at $85.63. This is up 6.3% from HYG’s price at the beginning of the year. When you add in dividends, HYG has given investors a 9.2% total return. That’s well ahead of the 6.8% return on DIA.
High yield bonds had a rough start to the year as well. But the rebound has been very strong. And as you’ll see, high yield bonds may have much more room to continue their advance.
Why High Yield Bond Returns Are Hot (and May Stay That Way)
To be fair, high yield bonds aren’t hitting a new all-time high like the Dow and S&P 500. Far from it!
These bonds are actually still recovering from what was a brutal two-year period.
As an asset class, high yield bond returns dropped steadily through much of 2014 and 2015. The primary reason for weakness was the decline in oil prices.
Many oil companies issued high yield bonds to raise money for new wells. When the price of oil dropped, investors started worrying about whether these companies would be able to repay their debts. In several cases, these energy companies have defaulted on the bonds.
The weakness from oil companies spread through the high yield bond market. Sometimes, bond fund managers were forced to sell good bonds alongside those with more risk. That’s because when investors pulled money out of these funds, the managers had to liquidate positions across all of their holdings.
Today, high yield bonds as a group have only made up about half of the losses from the beginning of 2014 (see monthly chart below).
The Fed’s ongoing zero (or near zero) interest rate policy, coupled with negative bond yields around the world have made it hard for investors to generate income. These investors are being pushed farther out the “risk curve.” That means they are willing to take more risk to get income.
This trend could help drive demand for high yield bonds. Meanwhile, the rebound in oil prices have made it possible for more U.S. drillers to turn a profit (and refinance debt).
Considering the rebound in oil and the global demand for yield, high yield bond returns could conceivably have much farther to go.
How to Play The High Yield Bond Rebound
I believe that high yield bonds could help boost your investment returns this year. But I wouldn’t recommend buying HYG or any other high yield bond fund.
The problem with bond funds is that they must buy new bonds when investors add more capital. And when investors pull capital out of these funds, the managers must sell bonds.
Unfortunately, high yield bonds aren’t as liquid as stocks, and often these managers must accept lowball pricing when they sell (or pay a premium when buying).
This hurts investors — even the investors who hold for the long-run — because the fund absorbs “slippage” or trading losses along the way.
Instead of buying bond funds, I recommend buying individual high yield bonds. You can even buy these bonds in your 401k account.
The key is to buy these bonds at a discount. This way, you’ll book capital gains when the bond matures and the company repays its debt.
When I’m researching a bond, I use what I call my C.A.S.H. system. Here’s what the acronym stands for:
- C = Cash – I want to make sure the company has enough cash to cover interest payments.
- A = Assets – The company should have valuable assets, which can be sold in a worst-case-scenario.
- S = Safety – You should buy cheaply, giving you safety. If the company can only partially repay, you still get your investment back.
- H = Health – It’s important to look at the health of the underlying business, to see if it can continue.
It’s not always easy to find bonds that measure up to this high standard. But in today’s market, there are more opportunities than normal.
If you’d like to see the actual bonds that I’m recommending for my readers, take a look at my Contract Income Alert trading service. We’ve had great success buying bonds at a discount and watching these bonds rebound. If you subscribe, you can follow along and buy these bonds in your own account.
Of course it’s very encouraging to see U.S. stocks hitting new highs. But if you want to add yield and some great capital gains in your account, consider buying high yield bonds today.