Junk bonds, or high-yield bonds are at a level that all income investors need to be paying attention to.  After a big recovery in the sector and after the markets have gotten off to a good 2012, investors have a lot to consider in risk versus income opportunities.  Standard & Poor’s tracks spreads of different bond grades over Treasuries and there is a definite growing appetite for risk.  While the investment-grade spread came down 1 basis point to 219 basis points, investors will want to pay very close attention to the speculative-grade composite spread.  This is junk bond investing, and that spread has tightened by 13 basis points to 691 basis points over Treasuries.  Many investors are seeking these higher yields in the “risk-on” trading strategy and they need to consider the pros and the cons both here at this time.

SPDR Barclays High Yield Bond (NYSE: JNK) carries a 7.7% listed yield and is up 0.25% at $39.00 against a 52-week range of $34.09 to $40.93 and it is the primary ETF we look at when it comes to the world of high-yield or junk bonds.  Then there is the iShares iBoxx High Yield Corporate Bond (NYSE: HYG) up 0.1% at $89.69 with close to a 7.7% yield and a 52-week range of $77.90 to $92.85, followed by the PowerShares Fundamental High Yield Corporate Bond Portfolio (NYSE: PHB) that is flat at $18.34 with a yield of about 6% and a 52-week range of $17.00 to $18.76.  You have to consider that the 10-Year Treasury yields close to 2%, but high-yield and junk bonds often pay 7%, 8%, or more.  Here are some of the top closed-end funds, although there are many more out there:

• Blackrock Corporate High Yield (NYSE: HYV): market cap of $396 million with shares up 0.3% at $12.02; 52-week trading range of $10.10 to $12.60; implied yield of 8.5%.
• Pioneer High Income Trust (NYSE: PHT): market cap of $480 with shares up 0.7% at $17.07; 52-week trading range of $14.12 to $18.08; implied yield of 9.6%.
• PIMCO High Income Fund (NYSE: PHK): market cap of $1.5 billion with shares down 0.1% at $12.62; 52-week trading range of $10.52 to $14.88; implied yield of about 8.5%.
• AllianceBernstein Global High Income Fund, Inc. (NYSE: AWF): market cap of $1.2+ billion with shares up 0.9% at $14.47; 52-week trading range of $12.43 to $15.41; implied yield of 8.3%.
• Western Asset High Income Fund II Inc. (NYSE: HIX): shares are up 0.4% at $9.84; 52-week trading range of $8.35 to $10.45; implied yield of about 10.0%.
• Western Asset High Income Opportunity Fund Inc. (NYSE: HIO): shares are up 0.8% at $6.32; 52-week trading range of $5.34 to $6.63; implied yield of 8.0%.

We do advise investors to study the current premium and discount that each closed-end fund trades at compared to the net asset value.  Some are discounts and some are premiums, and these can fluctuate wildly through time for a myriad of reasons.

While that is a composite and while the “BB” is now under 500 basis points over Treasuries, the “B” spread is now under 750 basis points over Treasuries.  Maturities matter here as the longer-dated notes and bonds command higher spreads than most shorter-dated instruments.  Still, this could be the beginning of a wave of continued interest in junk bonds.

What is interesting is that rising yields in Treasuries implies losses on the face value of bonds.  If the yields are rising because of an improving economic picture rather than because of inflation or because of a lack of faith in the underlying creditworthiness of the government, then the bond spreads are likely to contract further and that would drive the interest into high-yield junk bonds.

Be advised that not all junk bond funds are created equally outside of the ETFs.  Some closed-end funds use domestic junk bonds only, while some use international bonds.  Some include foreign-issue sovereign debt at junk levels or trading as though they are junk.  Aslo, some use a bit of leverage while others do not.  The dividend yields are “implied” because ethe closed-end funds pay monthly.

Another caveat needs to be mentioned… Some of the yields on financial quote screens also will differ from our implied yields because we do not include the capital gain distribution that comes with many of these.  They of course count toward your total return, but we like to look at the most recent ‘regular dividend’ when calculating yields.

We have provided a chart for the “JNK” ETF Below so you can see how much this sector has risen since Thanksgiving and then again since the selling climax of stocks and risk instruments (including junk bonds) in early October.

A true chartist would tell you to watch this current level closely.  If prices do not rise from here, it could be representative of a false break-out and that would imply a near-term top.  As long as the “risk-on” mentality prevails, these should do well.  The trick is watching longer-term Treasury yields.  With close to a 2% yield on the 10-Year Treasury Note, investors will seek higher returns as long as those returns are likely to have at least some degree of price stability.  If investors think that Treasury yields are likely to climb suddenly to 3% or even 4%, junk bonds will have some competition from the risk-free trade again.

As you would expect, there is no such thing as a free lunch in the financial markets.

JON C. OGG

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