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Junk Bond ETFs Will Eat Your Family

The last spate of volatility in HYG came back in mid-2013, when the Fed indicated a potential for tightening the reigns of quantitative easing and raising the Fed Funds rate. Many investors saw this as an opportunity to adjust the duration of their high yield bond holdings by moving to a shorter duration fund such as the Pimco 0-5 Year High Yield Bond ETF (HYS).

This strategy provides a measure of security from the threat of rising interest rates and still captures a higher yield than an aggregate bond portfolio. Another popular alternative to reduce interest rate risk is the use of bank loan ETFs such as the PowerShares Senior Loan Portfolio (BKLN).

If you still own high yield ETFs, I would continue to do so with the mindset that we may be closer to the end of this ride than the beginning. Prices are not indicating any kind of problem as of yet and the income streams are still solid for early adopters.

However, there will come a time when it will make sense to switch to higher credit quality areas such as investment grade corporate bonds or mortgage securities. I would recommend being flexible to shift your holdings in response to changing conditions when we reach an inflection point or see a convincing turn in price.

From a valuation standpoint, I still believe that emerging market bonds are offering a more attractive profile with respect to yield and price than domestic high yield fixed-income. The iShares JP Morgan USD Emerging Market Bond ETF (EMB) is currently a sector allocation in my income portfolio that is paying a yield of 5.00% and in my opinion has room for upside capital appreciation as well. Emerging market bonds certainly have their own unique set of risks; however, I am more inclined to integrate new holdings that have not already climbed to all-time highs.

By making these types of adjustments you can reduce the risk of being over-allocated to a stretched area of the fixed-income landscape. Staying ahead of the curve and being proactive with your portfolio will allow you to sidestep any major volatility with respect to credit or interest rates.

At the time of publication, the author held positions in HYG and EMB.

This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.

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