Patience Could Pay Off With Junk Bonds

High yield corporate bonds are among the best-performing corners of the fixed income market this year. That’s a positive sign because it indicates default rates are benign. It also indicates market participants are optimistic about the state of the economy. However, some experts believe there could be a pause in junk bonds ebullience.

But that doesn’t mean investors should take their eyes off exchange traded funds such as the WisdomTree U.S. High Yield Corporate Bond Fund (QHY). The ETF turned eight years old in April and tracks the WisdomTree U.S. High Yield Corporate Bond Index.

That’s a rules-based benchmark that sets QHY apart from cap-weighted counterparts. That’s because the gauge attempts to identify high yield corporate bonds that are sporting compelling fundamental and income traits. With a 30-day SEC yield of 6.40%, QHY delivers on the promise of income. The emphasis on fundamentals could prove advantageous if credit spreads suddenly widen from currently low levels.

QHY Merits a Query

QHY’s fundamentally driven approach could prove particularly useful over the near- to medium-term. That’s because some market observers believe credit spreads should be wider than they are today.

“Spread increases can happen fast,” noted Collin Martin of Charles Schwab. “We saw this a few weeks ago when concerns about the unwinding of the yen carry trade (borrowing at very low interest rates in Japan and investing in assets with higher expected return) sent risk assets sharply lower.”

“The average spread of the Bloomberg US Corporate High-yield Bond Index rose by 84 basis points (0.84%) in less than two weeks,” he continued. “As bond prices and yields move in opposite directions—and because spread is a component of yield—that pulled prices down relative to Treasuries.”

Bonds Fund QHY Methodology Could Shine Bright

QHY’s fundamental methodology could shine bright for risk-tolerant fixed income investors if the economy runs into trouble. While there are no guarantees that will happen, an ounce of prevention is worth a pound of cure, and QHY offers the prevention.

Consider the case of interest coverage ratios, which measure an issuer’s earnings before interest and taxes relative to interest obligations. That metric has been slumping for several months, but QHY could steer investors clear of the flimsiest issuers.

“Digging deeper shows a more worrisome trend, as many companies aren’t earning enough to pay off that interest expense,” added Martin. “Roughly one third of the companies in the Russell 2000 stock index are what are sometimes described as ‘zombie companies,’ or those whose three-year average earnings before interest and tax is lower than the average annual interest expense. Corporate profit growth could slow should the economy slow more than expected, making it more difficult for many issuers to make timely interest payments.”

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