Should You Bet on a Junk Bond Collapse?

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In the frantic search for high-yielding investments, junk bonds have captured the attention of investors dissatisfied with the ridiculously low rates on bank CDs and Treasuries. Yet as junk bonds increase in popularity, more critics have begun to warn that the junk bond market may be overheating -- setting the stage for a downturn that could seriously hurt newcomers to the sector.

You can almost take for granted that as soon as enough people see a new trend emerging, you'll be able to trade that trend via an exchange-traded fund. Sure enough, ProShares opened its ProShares Short High-Yield ETF (NYSE: SJB  ) yesterday. It aims to provide returns equal to 100% of the inverse of a high-yield bond index -- essentially letting shareholders short the junk bond market.

Is the new inverse junk bond ETF a good investment? Taking a closer look at what's going on in the junk bond market reveals a few interesting insights.

Understanding junk
High-yield junk bonds are a strange anomaly in the spectrum between stocks and bonds. On one hand, they're clearly bonds; they pay interest at regular intervals and return investors' money to them at maturity. But if you look at long-term trends of junk bonds, you'll see that they're also sensitive to movements in the stock market.

To figure out why, consider that companies issuing high-yield debt typically have weaker credit strength. While investment-grade bond investors bank on getting their principal back the vast majority of the time, junk bond issuers aren't nearly as secure, and their prices rise and fall with their issuers' financial prospects. Junk bonds do have a higher place in the capital structure; sometimes, they can earn recoveries even in bankruptcy proceedings in which common shareholders get nothing. Still, many junk bonds do involve a speculative element, not unlike stocks.

Over the past two years since the market meltdown, junk bonds have been on a tear that rivals the bull market in stocks. One junk index rose 57.5% in 2009 and 15.2% last year. That surge has pushed yields down considerably. Yet in part, those lower yields merely mirror very low Treasury rates; the spreads between junk and Treasury yields are very close to their long-term historical average. The popularity of junk bond ETFs iShares iBoxx $High-Yield Corporate (NYSE: HYG  ) and SPDR Barclays High Yield (NYSE: JNK  ) has made the riskier end of the bond market more accessible than ever to investors.

Are there any gains left?
The challenge for investors late to the junk bond game lies in figuring out whether the market has reached its limits. When you look at the prospects for junk bond issuers going forward, it's tempting to conclude that early investors have already grabbed all the easy gains.

Many big issuers of junk bonds, including CIT Group (NYSE: CIT  ) , AIG (NYSE: AIG  ) , and Ford (NYSE: F  ) , have already made huge recoveries from extreme financial stresses. In CIT's case, that bounceback followed a successful bankruptcy reorganization. Once companies regain stability, the big capital gains that produced such amazing returns for junk bonds in 2009 become mathematically impossible to duplicate. Investors get a yield bonus, but gains on the value of their bonds become much smaller.

That trend can push some junk investors in one of two unattractive directions. First, they may seek out even lower-quality names, which reopens the door to big jumps, but also further raises risk levels. Second, they may accept bonds with unattractive terms, such as payment-in-kind bonds, which essentially allow companies to defer cash interest payments by replacing them with more bonds.

Be careful
Even though you can now short the junk bond market with the new ProShares ETF, that doesn't mean you should. Equally compelling arguments supported using ProShares UltraShort 20+ Year Treasury (NYSE: TBT  ) , yet the leveraged inverse ETF has lost 22% of its value in the past year. If the junk bond market scares you right now, you may be best off simply taking no position in either direction.

You can find good ETF bets right now. Click here to read The Motley Fool's special free report, "3 ETFs Set to Soar During the Recovery," which includes great funds you shouldn't miss.

Fool contributor Dan Caplinger has too much junk at home. He doesn't own shares of the companies or funds mentioned in this article. The Fool owns shares of Ford, which is a Motley Fool Stock Advisor recommendation. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy is the highest quality you can find.

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  • Report this Comment On March 23, 2011, at 3:39 PM, jimmy4040 wrote:

    TBT is unrelated to a junk bond etf. No one with a lick of sense would have bought it one year ago. However if you bought when the market started it's rise in September you're up about 15-18%. Had world turmoil not driven people back to Treasuries temporarily you would have been up 30%.

    No less than Bill Gross has stated that yields will rise by at least 100 basis points after QE2 ends. (presuming) I get your point about junk bonds, but you mislead people about TBT which is a terrific hedge.

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