A Fund for an Overlooked Junk-Bond Niche

A glance at colleague Michael Aneiro’s Income Investing blog tells you high-yield bonds offer record-low yields, and lots of risk. Morningstar’s Samuel Lee argues there’s one last promising place to look: Bonds that are right on the cusp of investment-grade status, which many institutions have to dump when they’re downgraded to junk.

Here’s a steeply discounted closed-end fund to focus on them: BlackRock Credit Allocation Income (BTZ).

Bonds rates BBB and BB today yield 1.43% and 2.42% more than Treasury bonds of similar duration and thus they offer “the best bang for the buck in terms of risk,” Lee argues. But they get overlooked by many junk-bond managers:

Such “crossover” bonds have historically offered anomalously high risk-adjusted returns, likely because of regulations that force institutions to restrict themselves to investment-grade bonds. Bonds upgraded to investment-grade from junk attract lots of attention from these institutions, and bonds downgraded to junk from investment-grade get dumped en masse.

This anomaly persists likely because of leverage aversion. Many high-yield bond managers can’t use leverage, so they extend maturity or reduce credit quality to achieve target expected returns. (PIMCO funds are a notable exception, which likely has contributed to their excellent risk-adjusted returns.) Because investors fixate on realized yield rather than prospective total return, there is a lot of pressure to keep exposure to the lowest-quality junk bonds. Fear of tracking error also plays a role, as bonds rated CCC and under have an outsized influence on the returns of junk-bond benchmarks because of their high volatilities and high cash flows.

Exchange-traded funds such as SPDR Barclays Capital High Yield Bond ETF (JNK) and iShares iBoxx High Yield Corporate Bond ETF (HYG) have exposure, but the BlackRock CEF has more, and it’s unusually cheap, trading at a 12.4% discount to net assets. Here’s the math on why it makes sense to pay a higher expense ratio: 

This CEF charges an expense ratio around 1% before interest expense, 1.15% after. However, the fund’s 12.5% discount means its 6.2% net asset value yield translates to a 7.1% price yield, offsetting around 0.9% of the fund’s expenses. A 0.25% effective expense ratio for a high-quality 7%-yielding fund isn’t a bad deal at all.