ETF Talk: The Income and the Risk of High-yield Bonds

Volatility in the equity markets has been causing bonds to appear particularly enticing lately. Two weeks ago, I wrote about exchange-traded funds (ETFs) that use one of the safest investments, Treasury-only bonds. This week, I am highlighting high-yield bonds that can be purchased through ETFs. I also am identifying an exchange-traded note (ETN) that focuses on high-yielding investments.

Those of you who read my ETF Talk features regularly might remember my July 22 write-up that compared and contrasted ETFs and ETNs. That article should make this one easier to follow. Remember, if you have any questions about ETFs that you’d like me to answer and that you think might interest the rest of my readers, click here and I’ll respond in an upcoming ETF Talk feature.

Keep in mind that bonds are good for providing a steady income but that they also carry a risk to principal, as well as the possibility of default. With financial companies included among those that issue corporate bonds, you need to be aware that now is not the best time to enter these investments. However, as the current turmoil begins to wane and the economy rebounds, high-yield bonds will be one of the ways to ride the recovery.

Two of the high-yield bond ETFs that I want to bring to your attention are from the iShares family. The price of each has taken a hit recently but I’m tracking both of them for you.

The first that I have my eye on is the iShares iBoxx $ Investment Grade Corp Bond (LQD) fund. The ETF typically invests at least 90% of assets in the bonds of the underlying index, and at least 95% of assets in investment grade corporate bonds. It also may invest in bonds that are not included in the underlying index. In addition, the fund is able to invest up to 5% of assets in repurchase agreements, collateralized by U.S. government obligations, and in cash and cash equivalents. This fund should be less risky than traditional junk bond funds because it is oriented toward investment-grade bonds. Beware that investment-grade bonds could slip into the junk-bond category if credit conditions worsen further.

The second iShares ETF that I am tracking is the iShares iBoxx $ Liquid High-Yield Index (HYG) fund. The ETF invests at least 90% of assets in securities that comprise the index. However, it may invest up to 20% of assets in certain futures, options and swap contracts, cash and cash equivalents, and in bonds not included in the index. The index consists of the most liquid and tradable U.S. dollar-denominated, high-yield corporate bonds that are for sale in the United States.

An ETN that I want to bring to your attention is the ELEMENTS DJ High Yield Select 10 ETN (DOD). The index tracks the stocks with the highest dividend yield in the Dow Jones Industrial Average. Since an ETN is a debt obligation of the issuer, you need to consider the creditworthiness of the entity that offers the investment. In this case, the ELEMENTS ETN tracks the senior, unsecured obligations of Deutsche Bank that are linked to the performance of the index. This ETN does not invest in high-yield bonds but it is a debt instrument that aims to benefit from high-yield holdings. As I have written in past ETF Talks, ETNs started to surface last year and they now are beginning to proliferate.

Remember, I currently am not recommending any of the investments that I am highlighting in this feature. However, the fallout from the recent crisis in the financial system appears to have been factored into the current prices. Further damage certainly is possible, so steering clear of these funds right now seems wise. But when the inevitable rebound starts to take shape and the federal government’s bailout plan becomes reality, much of the overhang holding back these funds will be gone.