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Tired of bond yields that are invisible to the naked eye? It may be time to visit the junkyard.

High-yield bonds - also known as junk bonds - are a speculator's dream: They offer outsized yields and the opportunity for capital gains if things go right, and the prospect of steep losses if they don't.

Feeding the investing public's enormous appetite for yield-based products, Canadian ETF providers have rolled out at least three exchange-traded funds specializing in this risky corner of the U.S. bond market, with currency hedging thrown in to broaden their appeal with Canadian investors.

These products aren't for grandma. While they sport enticing yields - averaging more than 9 per cent in the case of the new ETFs from Claymore, iShares and Bank of Montreal - the downside of such eye-popping interest rates is a much higher risk of default compared with investment-grade bonds. So your actual return will almost certainly be lower than the advertised yield-to-maturity.



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Given the potential for losses, some advisers warn that the junkyard is no place for most retail investors. "Investing in high-yield bonds is a risk that is just not worth taking," U.S. money managers Larry Swedroe and Joseph Hempen write in their book, The Only Guide to a Winning Bond Strategy You'll Ever Need.

However, others say that, when used responsibly, high-yield bond ETFs can serve as a complement to the higher-quality government and investment-grade corporate bonds in a portfolio. The important thing is not to get too greedy.

"I wouldn't put more than 10 per cent of my fixed-income portfolio in something like this," says Hank Cunningham, fixed-income strategist at Odlum Brown and author of In Your Best Interest: The Ultimate Guide to the Canadian Bond Market.

Consider the iShares U.S. High Yield Bond Index Fund, which is designed to track the Markit iBoxx USD Liquid High Yield Index. The average credit rating of the ETF's 290 bonds is B+, which is four notches below Standard & Poor's lowest investment grade of BBB-. Riskier still, more than 16 per cent of the bonds are rated CCC+ or lower, which means the issuer is either "vulnerable" or "highly vulnerable" to default.

According to S&P, the default rate for all U.S. speculative-grade bonds was 10.7 per cent in January. But it expects the default rate to fall to 5 per cent by December, assuming the economic recovery continues. If the economy performs worse than expected, however, the default rate would be closer to 7 per cent, S&P predicts.



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Mr. Cunningham likes high-yield bond ETFs right now for a few reasons. Because ETFs are broadly diversified, a few blowups here and there won't do significant damage to a portfolio, he says. And while high-yield bonds are coming off a strong year in 2009 as they rebounded from the credit collapse, he expects the asset class to continue to perform well as the strengthening economy gives companies a lift.

In that sense, high-yield bonds behave much like equities, rising in response to improving fundamentals and falling when the economic and earnings outlook darkens. By contrast, higher-quality government and corporate bonds tend to be more sensitive to changes in interest rates. The lack of correlation between high-quality and low-quality bonds improves the diversification of a fixed-income portfolio.

John De Goey, investment adviser with Burgeonvest Bick Securities, says he doesn't recommend high-yield ETFs to his clients. However, he wouldn't stand in their way if they wanted to invest, as long as they kept their exposure within reasonable limits - say 5 per cent of the portfolio for a "moderate" investor.

"Now, I wouldn't do it for a little old lady," he adds. Some investors "are so hungry for yield that I think they're reaching too far."

ETFs that track an index aren't the only way to play the high-yield bond market. If you'd prefer to have a fund manager picking bonds on your behalf, actively managed mutual funds are the way to go. The fees are typically higher, but a seasoned manager can separate the ticking time bombs from the higher-quality credits, which is an advantage you don't get with a passive indexing strategy.

One example is the PH&N High Yield Bond Fund, which differs from the new crop of ETFs in several respects. For one thing, it holds a much smaller number of bonds - usually 30 to 40 - and most are from Canadian issuers. Also, it focuses on bonds rated BBB and BB, which are higher up the quality scale.

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"We are not your typical high-yield bond fund," says Hanif Mamdani, lead manager of the PH&N fund. "It's more of a middle-of-the-credit-spectrum cross-over product."

By selecting bonds at or slightly below investment grade, Mr. Mamdani says he can generate similar returns without the volatility of a true high-yield portfolio.

Since the fund's inception in 2000, it has racked up an annualized return of 8.7 per cent, compared with a 6.7-per-cent return for the Merrill Lynch U.S. High Yield Master II Index, a benchmark for high-yield corporate bonds. The PH&N fund's standard deviation - or volatility - has been about half that of the index.

For his part, Mr. Cunningham has been recommending high-yield bond ETFs to his clients. He's especially fond of the iShares ETF, because it holds 290 bonds - more than twice as many as either the BMO or Claymore funds.

"That's the sort of number you want to see in a high-yield fund," he says. Given the risks of default, "your money has got to be spread across the country, across industry sectors and across companies so you're not overly exposed."

SNAPSHOT OF TWO HIGH-YIELD ETFS

iShares U.S. High Yield Bond Index Fund

Ticker: XHY

Number of holdings: 290

Based on: Markit iBoxx USD Liquid High Yield Index

Average yield to maturity: 9.3 per cent

Average S&P credit rating: B+

Currency hedged: Yes

Management fee: 0.6 per cent

Claymore Advantaged High-Yield Bond ETF

Ticker: CHB

Number of holdings: 127

Based on: Barclays Capital U.S. High Yield Very Liquid Index

Average yield to maturity: 10.1 per cent

Average S&P credit rating: B/B+

Currency hedged: Yes

Management fee: 0.5 per cent.

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