Cash-starved investors are looking everywhere for income. Although many have gravitated toward dividend-paying stocks for their high yields and growth potential, bond investors have also looked toward alternatives to ultra-safe bank CDs and Treasury bonds and the stingy payouts they currently offer.
In particular, high-yield corporate "junk" bonds have risen dramatically in popularity in recent years. Even as many investors have focused on the doubling of the S&P 500 stock index since early 2009's lows, junk bonds have put in equally impressive returns. The resulting popularity has driven more capital into the junk bond market and has helped many big corporate issuers get the financing they need to cut their financing costs and enhance their profits.
The big move into junk bond ETFs
To get a sense of the broad trend in an asset class, it pays to look at exchange-traded funds covering that space. When an investment gets popular, you'll almost always see ETFs swooping in to capitalize on investors putting their money into it.
That's been the case with junk bond ETFs. Between the SPDR Barclays High Yield Bond ETF and the iShares iBoxx High Yield Corporate Bond ETF, demand for high-yield corporate bonds has never been higher. Now, both junk bond ETFs have more than $10 billion in assets under management. Given that share prices for both ETFs have risen about 50% from 2009's lows -- not even including the impressive payout yields that they've made to ETF shareholders during that period -- the interest is easy to understand.
High-yield bonds are structured like any other bond. In exchange for money upfront, bondholders receive the right to regular interest payments and get their initial investment back when the bonds mature. Yet while junk bonds look like ordinary fixed-income investments, their prices often track stocks more closely than other types of bonds. That's because unlike bonds of higher credit quality, for which repayment is almost a given, junk bonds involve a somewhat higher risk of default -- and when bonds default, they can cost bondholders all or part of their principal.
The big winners
Whenever large index-tracking ETFs get into an asset class, there's potential for market distortion as increasing amounts of money go after the same investments. Although the two big junk bond ETFs don't track the same index, you'll find many of the same companies among the top issuers for both:
- Bonds from Ford's (NYSE: F ) Motor Credit division play a big role in the indexes. The automaker has been gearing up toward trying to get its credit rating upgraded to investment-grade status, which would save the company millions in interest costs.
- Sprint Nextel (NYSE: S ) seems like the odd mobile player out among its larger rivals, despite Sprint's having gotten access to the iPhone. With huge infrastructure costs involved in creating wireless networks, Sprint needs all the access to capital it can get.
- CIT Group (NYSE: CIT ) emerged from a pre-packaged bankruptcy plan in late 2009 that cut a huge amount of the company's debt. Yet as a leading financier for small business, CIT benefits from being able to get junk bond capital.
- As a hospital operator, HCA (NYSE: HCA ) has a lot of capital tied up in its facilities. As HCA navigates through changing health-care laws, capital financing helps the company keep costs down.
- Even though newly public Caesars Entertainment (Nasdaq: CZR ) floated only a small amount of stock in its IPO, it has plenty of debt -- and that debt figures prominently in junk bond ETFs.
Of course, these issuers can't go directly to ETFs to raise capital. But if they're mindful of how they issue new bonds, they may be able to get more of their debt included in the indexes that junk bond ETFs track -- creating demand that should result in lower interest rates.
Even after a big spike in prices, junk bonds aren't necessarily a bad investment, especially compared to Treasury bonds. What's important, though, is to understand the potential impact that junk bond ETFs and other institutional investors can have in the pricing of individual bonds -- as well as the positive impact that easy access to junk bond financing can have for the shares of those issuing companies. If these companies play their cards right, they can use the influx of junk bond money to reward their shareholders.
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