Junk Bond ETFs (HYG, JNK): When Might "High Yield Corporates" Be Desirable?

In mid-July of last year, I offered a very attractive ETF solution for widening "credit spreads." Specifically, I suggested that one could own the iShares Lehman 7-10 Year Treasury Bond Fund (IEF) and "short sell" the iShares iBoxx High Yield Corporate Bond Fund (HYG).

This approach proved exceptionally lucrative. IEF has returned 15.5% since 7/13/07. Meanwhile, a simultaneous short-selling hedge of HYG resulted in 0%. In essence, the risk associated with a widening spread between "high-yield corporate" (a.k.a. junk) funds and intermediate term U.S. treasury funds had been neutralized.

(The short-selling hedge could have been profitable as well... were it not for the 7.5% annual yield that the iShares iBoxx High Yield Corporate Bond Fund generated. Effectively, the high yield income stream compensated for the depreciation in price.)

The "credit spread" between the iShares Lehman 7-10 Year Treasury Bond Fund (IEF) and its comparable high-yield debt equivalent has continued to widen. The difference between IEF's annual yield and HYG's annual yield in July 2007 was roughly 3%. Today, the difference in yield alone is north of 4.5%.

Owners of the iShares Lehman 7-10 Year Treasury Bond Fund (IEF) may expect an annual payout of 3.5% while the iShares iBoxx High Yield Corporate Bond Fund (HYG) is at an 8% distribution yield. And, of course, this tells individuals nothing about the appreciation or depreciation component.

Yet here's the question that may determine what takes place over the next 8-9 months: Will the spread between high-risk debt and low-risk debt tighten once the Fed is done easing? If so, junk bond ETFs figure to be a likely beneficiary.

The iShares iBoxx High Yield Corporate Bond Fund (HYG) offers a published distribution yield of 8.3% at the present time, with the income paid out monthly. If investors get a whiff of a late 2008/early 2009 recovery, HYG would likely appreciate in value as well. (Economic recovery tends to go hand-in-hand with greater appetite for risk.)

The SPDR Lehman High Yield Bond Fund (JNK) has an 8%+ distribution yield right now as well. However, the ETF has only been around for a few months.

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