Investors who are seeking a higher return will still find it in corporate bonds, but it is imperative that they pay attention to rising interest rates.
The VanEck Vectors Emerging Markets High-Yield Bond ETF, for example, yields 5.3 percent and is trading just below its 52-week high of $24.05.
The fund aims to outperform the Bank of America Merrill Lynch High-Yield U.S. Emerging Markets Liquid Corporate Plus Index. Its holdings are US dollar denominated bonds issued by non-sovereign emerging market entities that are rated below investment grade.
According to Michael Contopoulos, director of fixed income at Richard Bernstein Advisors, high-yield emerging market corporate debt is more appealing than high-yield debt in the United States.
“High-yield emerging market corporate bonds actually have a lower default rate than high-yield US corporate bonds,” he said. “One [reason] is that many high-yielding emerging market companies are national champions. Consider Petrobras in Brazil.”
The VanEck ETF’s holdings include Mexico’s petroleum company, Petróleos Mexicanos, and Dubai port and logistics company DP World Ltd.
“In general, emerging market debt has lower market sensitivity to US interest rates…
Contopoulos explained that the higher the yield, the more cushion you have to absorb interest rate shock.
Bond fund investors should be aware that when interest rates rise, prices fall and the value of their ETFs falls, just like the underlying bonds.
High-yield bonds issued in the United States
This year has seen a surge in demand for high-yield debt, also known as junk bonds in the United States. Because of the higher risk of default, these bonds are rated below investment grade and have higher yields.
They are held by funds such as the iShares iBoxx $ High-Yield Corporate Bond ETF, which has a yield of 4.55 percent. The SPDR Bloomberg Barclays High-Yield Bond ETF offers a similar yield. Both funds were less than a dollar away from their 52-week highs as of Wednesday afternoon.
Contopoulos prefers the shorter end of that market, i.e. a year or less.
“I think it’s appealing to have a short maturity period with a high yield. It is not rate sensitive, and the coupons are relatively large,” he explained. “Default risk is front-loaded to early maturities in a cyclical environment emerging from a recession.”
“If [a company] can make it through that six months, continue to pay the interest on debt, it won’t have a problem sustaining its business, and short-maturity high-yield actually trades as if there will be relatively high defaults,” Contopoulos added. “The front end of the high-yield maturity curve has far too much default risk priced in. We believe there is value there.”
A fund that invests in that strategy is the SPDR Bloomberg Barclays Short-Term High-Yield Bond ETF. The dividend yield on the ETF is 4.82 percent, and its price is up about 1.5 percent year to date.
Corporate bonds with the highest ratings
Investment-grade corporate bonds are appealing investments, but if interest rates rise too quickly, they may suffer.
The yields on IG corporate bond funds are reasonable, but not as high as those on high-yield funds. The iShares 10+ Year Investment Grade Bond ETF yielded 3.34 percent, but its price is currently about $7 lower than its 52-week high of $74.42 set in August.
The Vanguard Long-Term Corporate Bond Index Fund ETF yields 3.23 percent and is about 7% lower in price year over year.
“Corporate bonds have two components. “You have the interest rate component and the credit risk,” Contopoulos explained.
“The interest rate component will hurt you, but the credit risk component, the spread between corporate bond yield and Treasury yield, I believe there is still room to compress,” he said.
Contopoulos stated that there are ways to mitigate some of the interest rate risk by investing in specific corporate bond ETFs.
A corporate bond fund that hedges against rising interest rates is the ProShares Investment Grade Interest Rate ETF. The fund seeks to outperform the Citi Corporate Investment Grade (Treasury Rate-Hedged) Index in terms of performance.
The index includes long positions in investment-grade bonds issued by US and foreign entities, as well as short positions in US Treasury notes and bonds.
The ETF yields 2.52% and was trading near its 52-week high.
“We still like long maturity investment grade corporate bonds on a spread basis, not an all-in yield basis.” “That’s where a lot of issuance happened in 2020,” Contopoulos explained. “Thirty-year investment grade corporate bonds look appealing to us on a spread basis. You could do well if you could hedge the interest rate risk.”
Contopoulos believes investors should consider where the best opportunities are in the fixed income market over the next one to three years. “It will be difficult to achieve a total positive return on fixed income.”
Individual investors, he says, will need to use products that can help them hedge their holdings in various ways.
“ETFs enable investors to do sophisticated things that they couldn’t do five years ago,” Contopoulos said.