Junk bond junkies are going short (term)

Rising interest rates have yield-starved investors moving into short-term high-yield-bond funds, and mutual fund companies are planning new products to meet the demand.

Fidelity Investments and Eaton Vance Corp. are the latest mutual fund companies to plan to offer such funds. They both unveiled plans to launch them this month, pending approval from the Securities and Exchange Commission.

Wells Fargo & Co. launched the first short-term high-yield-bond fund, the $1.4 billion Wells Fargo Advantage Short-Term High Yield Bond Fund (STHBX), way back in 1997, but the most popular short-term high-yield options so far have been exchange-traded funds.

Since May, when interest rates began to climb upward, investors have shown a clear preference for shorter-term funds in the high-yield space.

“You're getting pretty much all the yield and a lot less of the interest rate risk,” said Louis Kokernak, principal at Haven Financial Advisors.

The $2.9 billion Pimco 0-5 Year High Yield Corporate Bond ETF (HYS) and the $1.7 billion SPDR Barclays Capital Short Term High Yield Bond ETF (SJNK) have seen inflows of $931 million and $560 million, respectively, since the beginning of May, according to IndexUniverse LLC.

The two most popular longer-term high-yield-bond ETFs, the iShares iBoxx High Yield Corporate Bond ETF (HYG) and the SPDR Barclays High Yield Bond ETF (JNK) have suffered net outflows of $492 million and $2.29 billion, respectively.

The move turned out to be good for advisers such as Mr. Kokernak, who uses the SPDR short-term ETF.

The SPDR Barclays Capital Short Term High Yield Bond ETF, which has an average maturity of about 3.5 years, lost just under 1% in the second quarter when interest rates shot up 100 basis points to 2.5%. Its longer-dated sibling, which has an average maturity of 6.75 years, lost about 2.5% during the quarter.

For the year, the shorter-term ETF is up 2.67%, while the longer-term one is down 0.35%.

One of the big reasons for the outperformance is that even though the durations are shorter, there isn't a big difference in the yield the funds pay out.

The yields on the two SPDR High Yield Bond ETFs are 5% for the short-term one and 6% for the long-term one, for example. The Pimco 0-5 Year High Yield Bond ETF has a yield of 4.7%.

Those high yields create a cushion against rising interest rates, which cause bond prices to drop.

Interest rates have come back into the spotlight after an uneventful July as the possibility of the Federal Reserve Bank cutting back on its asset purchases has become more realistic.

Last week, initial jobless claims dropped to 320,000, the lowest level since Oc! tober 2007. It's caused the 10-year U.S. Treasury note to surge to 2.88%, its highest level since August 2011.

Even though the short-term junk bond funds will protect against rising interest rates, Mr. Kokernak said it's important to keep in mind they won't offer extra protection from the other spectrum of risk embedded in the funds — credit risk.

“If there's a risk of recession, junk bond prices could crater,” he said. “That's true for short-term junk, too.”