The Goldilocks of Bond Funds

It may well be true that struggling corporations are being lulled into a cheap money trap — taking advantage of Fed-manipulated rates to acquire cash, when what they really need to acquire is more customers. And if the borrowed money runs out before the companies can turn it into revenue and profit growth, bond investors will certainly get the short end of the stick.

Still, fixed-income investors have to put money to work somewhere. This leaves bond investors in a “lesser of evils” comparison… and a goldilocks approach may be the answer.

Consider three bond markets — Treasurys, high-quality corporate and high-risk junk —each with increasing risk profiles and yields. Exchange-traded funds (ETFs) make jumping in and out of these bond investments as easy as buying and selling stock.

So let’s consider which bond type is the best choice, if you must make new, fixed-income investments in 2014.

Treasurys, of course, pay the slimmest yield with the iShares 7-10 year Treasury ETF (NYSE: IEF), paying just 1.69%. High-quality corporate bonds pay more, with the iShares Investment Grade Corporate Bond ETF (NYSE: LQD), yielding 3.84%, which is more than double what Treasurys pay. Finally, high-yield junk bonds pay investors for the higher risk of default, with the iShares High Yield Corporate Bond ETF (NYSE: HYG) yielding 6.17%, or 60% more than high-quality corporate bonds.

Based on yield alone, high-quality corporate bonds provide a good compromise between yield and risk. Call it the “goldilocks” choice.

Beyond yield, short- to medium-term investors should look to invest in bond funds that are showing increasing relative strength. Doing so provides ample opportunity to earn yield-beating returns as the price of the chosen ETF rises faster than comparable investments.

In this regard, both high-quality and high-yield corporate bonds are showing increasing relative strength against Treasury bonds. A bullish breakout in the ratio of LQD-to-IEF shows this well:

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And while high-quality corporate bonds are clearly outperforming Treasury bonds, they’re also selling at a discount to junk bonds. Here’s a ratio chart showing the relative performance of LQD-to-HYG.

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This ratio slowly declined throughout 2013, as investors favored higher-yielding junk bonds. But now the ratio has fallen to the Fibonacci buy zone, where it’s probable that the ratio begins to increase during the first half of 2014.

If this ratio increases, you’ll do better off investing in high-quality bonds as junk bonds will come under pressure.

As we’ve discussed many times before, buying individual corporate bonds can be risky as the winter economic season will surely put many companies out of business.

Yet, investing in a diversified bond fund, such as the iShares Investment Grade Corporate Bond ETF (NYSE: LQD), limits the risk of significant losses spurred by the bankruptcy of one company.

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Categories: Bonds

About Author

Adam O'Dell has one purpose in mind: to find and bring to subscribers investment opportunities that return the maximum profit with the minimum risk. Adam has worked as a Prop Trader for a spot Forex firm. While there, he learned the fundamentals of trading in the world’s largest market. He excelled at trading the volatile currency markets by seeking out low-risk entry points for trades with high profit potential. An MBA graduate and Affiliate Member of the Market Technicians Association, Adam is a lifelong student of the markets. He is editor of our hugely successful trading service, Cycle 9 Alert.