How Risky is Your Bond ETF?

The genesis of this post is the article

"Investors Get Complacent in Search for Yield"

at the bond site Learn Bonds. The article focuses on the move toward leniency of terms for lower-rated issues in bank loan funds as investors clamor for higher yields.  Simply, risky issuers usually have to bend over backwards in offering protective covenants to attract investor money.  Not so much today, as the Fed has driven yields into the ground and kept them there for the past few years and seemingly for the forseeable future.  This is part of the Federal Reserve's program of trying to push investors into taking risk.

OK, so the playing field has potholes.  How does the DIY investor check this out?  Well, let's go through a simple example where we look at a risky fund and do a first cut check.

The fund is  BKLN.  First off, go to Yahoo! Finance; put in the ticker symbol.  You'll find the yield is 4.15%.

Source: Yahoo Finance

If you go to www.morningstar.com, put in the ticker, and scroll down the right-hand side, you'll find that BKLN has a low duration. I n today's historically low-yield environment, this tells you right off the proverbial bat that this is a risky issue, i.e. 4.15% for a low duration fund is a flag!  Remember that, by the time the Fund gets to you, a lot of people have taken a cut! Thus, the underlying loans have considerably higher yields!

OK...so back to Yahoo! Finance and scroll down the right-hand side and click "Holdings." This gives you a page that lists the Fund's top 10 holdings.  You'll see names you don't recognize. That's okay--unless you're a professional bond trader.

Go ahead and scroll down a bit further, though, and find the following breakdown of the Fund by rating:

Source:  Yahoo! Finance

This is what we are after.

The Table shows that only 9% of the ETF is rated above BBB. BBB happens to be the lowest rating to qualify for the "investment grade" category.  Many pension funds can only invest in investment grade and higher fixed income instruments.

The bulk of the ETF is invested in B rated issues.  Here is how S&P defines the "B" rating:  "More vulnerable to adverse business, financial and economic conditions but currently has the capacity to meet financial commitments."  The "more" refers to the next higher category of "BB" which in turn specifies "faces major ongoing uncertainties to adverse business, financial and economic conditions."

So, the bottom line for the DIY investor is simply this:  know going in the risk you are taking.  If you want to juice your yield, risky funds will do it; but, if you are not careful and at least don't limit your exposure, they also can wreck an investment strategy.  Many learned this the hard way in 2008.