Where You Can Find a Better Yield Play Than Junk

Bond investors willing to take on credit risk are getting paid less and less for their efforts. The yield on corporate junk bonds has continued to drop through 2012, with BB-rated issues falling below 5%.

US High Yield BB Effective Yield Chart

US High Yield BB Effective Yield data by YCharts

Amid the declining payout, investors also have plenty to worry about. Short-term, how Washington handles the fiscal cliff issue will have an impact on whether the economy manages to avoid another stall-out. Longer-term there’s the concern all bond investors have that the continued easing policy by the Federal Reserve will eventually cause inflation to ramp up, more than it might otherwise without the Fed expanding its balance sheet.

To state the obvious, that’s not ideal for any bonds, but it’s especially trying for the junk segment, where bond values are determined more by economic factors than the direction of interest rates. Just take a look at what happened to the SPDR Barclays High Yield bond ETF (JNK) compared to the high-quality Vanguard Total Bond ETF (BND) during the heart of the last recession.

JNK Total Return Price Chart

JNK Total Return Price data by YCharts

If you’re still determined to take on that sort of credit risk, bank-loan debt could be a smarter way to dip your toes into the junk segment. Bank loan bonds are most definitely still junk. But with a few nice caveats. First off, their interest rate floats. Granted we may not see rising rates any time soon, but with a slug of bank loan bonds you are better positioned when the time comes.

Bank loan debt is collateralized, so it’s senior to other types of debt in a company’s capital structure. Translation: in the event of a restructuring/bankruptcy, bank loan investors get paid before straight-up uncollateralized junk debt investors.

None of that should be construed as saying bank loan bonds are safe. They sure ain’t Treasuries. But moving forward their unique attributes make them a compelling investment when stacked up against standard junk bonds.

The $830 million PowerShares Senior Loan ETF (BKLN) currently has a 4.8% yield in line with the SPDR Barclays High Yield ETF. Don’t expect either portfolio to provide ballast when economic worries bubble up. But the bank-loan ETF’s swoon during last year’s debt-ceiling sell off was indeed a little less painful.

BKLN Total Return Price Chart

BKLN Total Return Price data by YCharts

In either case, with that level of volatility, yield chasers are forewarned what reaching for a 4.8% payout today could entail if the economic picture darkens.

Carla Fried is an editor for the YCharts Pro Investor Service which includes professional stock charts, stock ratings and portfolio strategies.

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