Today’s high interest rates represent an exceptional buy-and-hold investing opportunity to generate a substantial amount of passive income while taking some risk of the table in what has become an increasingly expensive market. It’s unlikely, though, that you will hear this type of message from your broker.
At Ziggma, our mission is to help private investors build wealth sustainably and reach their long-term investing objectives. Running on a subscription model, we are free from the types of conflicts of interest that your broker is subject to. Whether you trade a lot or whether you pursue a buy-and-hold investment strategy has no impact on our revenue. Your broker, on the other hand, makes money through your transactions, one way or another. It has a considerable interest in you buying and selling as frequently as possible.
This is why your broker is unlikely to point out to you that can currently lock in some of the highest yields the market has seen in decades. And hold these investments for the foreseeable future while just cashing in coupons”.
A very rare occasion
Today’s high interest rate environment is a boon to investors pursuing a buy-and-hold investing
approach. It lets them take a breather from a pricey stock market that is difficult to navigate while generating a substantial amount of passive income. Long-term investors can currently lock in 5-9% bond yields, depending where they want to be on the risk spectrum. This level of return sets quite a high bar for stocks. With the equity risk premium at multi-year lows, stocks are facing very stiff competition from bonds.
As the following chart by the Federal Reserve Bank of St. Louis shows, US high yield rates significantly exceeded today’s levels only twice in the past 10 years.
Buy-and-hold investing with bond ETFs
Bond ETFs represent a highly convenient means to capture today’s high yields in a convenient and cost-efficient manner. While you have many options at your disposal, we like some of the larger high yield US bond ETFs, as the US economy continues to show solid growth momentum.
Seizing the opportunity with high-yield bond ETFs
A high-yield bond ETF primarily invests in high-yield or “junk” bonds, which are debt securities rated below investment grade. These bonds carry a higher risk of default compared to investment-grade bonds, but they offer higher yields to compensate for the additional risk. By replicating the performance of a specific high-yield bond index, investors get a diversified exposure to a portfolio of junk bonds in a single investment. This diversification considerably mitigates the risks associated with individual bond defaults.
While high-yield bond ETFs offer the potential for enhanced returns, they also come with increased volatility and credit risk, making them suitable for investors with a higher risk tolerance and a long-term investing horizon.
8.3% yield with the iShares 0-5 Year High Yield Corporate Bond ETF
SHYG is a highly diversified high yield bond ETF issued by BlackRock’s Ishares program and potentially a very suitable option for private investor with a long-term investing approach. (Disclosure: We do not receive compensation from iShares, or any other provider mentioned in this article. Ziggma team members presently hold shares in this ETF or other ETFs mentioned in this article).
The ETF’s US$5bn in assets are spread over no less than 879 issuers, giving investors a portfolio of high yield bonds that is as diversified as it gets. Given its size with over US$5 billion in assets under management and with one of the most renowned ETF issuers as its sponsor, liquidity should not be a concern for private investors as it can be with smaller ETFs from niche issuers, even in tumultuous market times.
Got a certain yield level in mind? Set your yield range in seconds and screen for suitable ETFs with our free ETF screener.
SHYG’s 8.3% 30-day SEC yield means that absent defaults the fund’s assets will generate an annualized yield of 8.3% for your portfolio, or $830 per year when you invest $10,000.
What is the risk?
There are two principal risks when investing in high yield bond ETFs.
Risk 1: Default risk by bond issuers due to an economic downturn
In the event of a recession, the default rate among high yield bond issuers is going to rise. It can go up well into the high single digits. However, in the world of bonds, a default does not mean zero recovery. In fact, bond investors will generally get all or some of their money back, as bond investors, unlike equity investors, are first in line in an insolvency situation.
That said, default rates are currently low as the US economy shows a great deal of strength. Asset manager Neuberger Berman expects defaults in the U.S. high yield credit market to increase from the exceptionally low levels experienced in 2021 and 2022, but to still remain in line with long-term averages and well below levels realized in past recessionary periods.
In conclusion, most pundits agree that if the US were to enter into a recession it would be mild. So default rates are expected to remain well below the historical average.
Default risk is mitigated by the ETF thanks to the diversification effect of a portfolio comprising close to 900 companies.
Example: Assuming an absolute worst-case scenario of a 5% annual default rate and a 50% recovery rate based on extensive research out by Moody’s, the 8.3% yield would suffer a drop of around 2.5% to 5.5% net of fees. This drop will be partially offset by an increase in running yield as new issuances at higher yields are purchased by the ETF over the coming years.
In our view, even in a worst-case scenario, the 30-day SEC yield as of the time of this writing should not be expected to drop below 6% – a rate of recurring income that provides a solid foundation of any portfolio built on a buy-and-hold investing strategy.
Risk 2: Interest rate risk
Rising interest rates will push the value of any bond ETF lower, with the exception of floating rate bond ETFs, as bond yields and bond prices have an inverse relationship. When interest rates rise, so do bond yields as the discount rate used to value these future cash flows increases. That said, most experts agree that we are at or very close to the end of the rate hiking cycle so that interest rate risk can be considered a minor risk at this time.
When is the right time to buy a bond ETF?
The absolute right time to buy would be when interest rates peak. While we have no crystal ball in our office, we can point to the many experts that seem to agree that interest rates are unlikely to go much higher.
That said, if you are pursuing a buy-and-hold investing strategy, anytime is a good time. Even if rates go up and the price of your ETF goes down, you will receive your cashflow. Eventually, as the rate cycle turns, your paper losses will revert.
As a long-term investor, you will probably know that it’s near impossible to time a market bottom, and that cost-averaging through consistent investing is the way to go.
What is an alternative high yield bond ETF to SHYG?
The closest alternative to SHYG is the SJNK ETF, which is issued by State Street. It also targets short term high yield bonds, and is very sizeable with assets of $3.7bn. With State Street as the issuer, there is little to no counterparty risk. The following table provides for a comparison of the two ETFs’ key performance indicators and fund characteristics.
How does the yield of high yield bond ETFs compare “risk-free” bond ETFs?
First of all, nothing in investing is risk-free. That said, government issued bonds are as close to risk-free as it gets. Regulators for one think so. When banks or insurance companies invest in government debt by well-rated countries, they incur no risk charge, because government debt is assumed to be risk free. The Vanguard Short-Term Treasury Index Fund ETF fits the bill. It invests primarily in high-quality (investment-grade) U.S. Treasury bonds with a dollar-weighted average maturity of 1 to 3 years. It’s 30-day SEC yield stands at 5.10% or 5.06% after fees. So the yield difference between SHYG and VSGH is a little less than 3% net of fees.
An opportune time
Whether you go with the higher-yield, riskier option or the safe US government bond ETF, you will add a solid source of recurring income to your portfolio. At rates between 5-9%, you will quickly see the compound effect play out in your long-term investing journey.