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Put Some JNK in Your Portfolio's Trunk


High-yield ETF is a well-diversified investment worth considering.

Yesterday, in several accounts I manage, I decided it was time to put some junk in their portfolios. The junk I'm referring to is the high-yield ETF – JNK.

The primary reason for adding JNK is the still very wide yield spread over US Treasuries (see chart below), which, when combined with high-yield data from credit default swaps, suggests default rates >50%. Yet, every expert I know, including Marty Fridson and Ken Bann (with whom I shared yesterday's Jefferies & Co. panel discussion), have default rates below 20%.

Click to enlarge

As I understand it, the first peak in defaults is expected later this year (<10%) followed by a second, higher peak, which will occur later in 2010. This is due to the unraveling of those very generous covenants issued before the credit bust. So, when the super-shaky notes (CCC rated, for example) start coming due, the ability to refinance them won't exist. However, it does appear that the wide spread (double its prior peak in 2002) more than anticipates the worse-case scenario. Moreover, the better quality junk (there's an oxymoron) -- many of which are held in JNK -- aren't in such danger.

Interestingly, most equity investors ignore the fixed-income market, often relegating it to the asset allocation decision at best, or some second-class investment category at worst. And there's good reason to be hesitant about making individual investment decisions in any asset class that the serious student of investing may have limited knowledge and skill sets to execute well upon. However, the tactical asset decision of owning an investment vehicle that generates a 15% dividend return in an area that seems to have discounted the end of capitalism as we know it, appears warranted - especially in the slow-growth era the world economy is headed into.

High Yield Via the ETF Route

Just like the strategic decision to tilt a portfolio toward emerging markets, the tactical decision to add a high-yield position to a portfolio is best via ETFs. As noted above, any area where knowledge and skill sets are outside our core competencies, plus the need for maximum diversification, is best served via the ETF route. Perhaps this is why 8 of the top 15 positions held by a major institutional investor like Harvard Management portfolio are ETFs (EEM, EWU, EWW, EWZ, EZA, FXI, INP, AND RSX).

Investment Strategy Implications

Now that stocks have bounced off their devilish low of 666 (666.79 to be exact), taking a little money off the table seems advisable. With high-yield spreads so wide, JNK, with its 15% dividend yield, is a well-diversified investment worth considering for those funds.
No positions in stocks mentioned.
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