Bullish on Junk, Mid-Caps

Junk bonds still look attractive, even if some investors are fleeing the high-yield ETFs. Also, mid-cap stocks have more room to run.

Investors' hunger for the juicy yields of junk bonds is a major theme this year, but you wouldn't know it from this month's activity in junk-bond exchange-traded funds.

Deflated hopes for more Federal Reserve easing, a weak payroll report, and fresh euro-zone worries spurred investors to pull $527 million from the two biggest junk-bond ETFs in the week that ended Wednesday, part of the first notable withdrawals in months.

Could investors' appetite for high yield turn sour so quickly? It seems doubtful. This is a trickle of money compared with the $6 billion that has flowed this year into the $11.5 billion SPDR Barclays Capital High Yield Bond ETF (ticker: JNK), and the $14.2 billion invested in the iShares iBoxx High Yield Corporate Bond ETF (HYG) this year. The HYG has fallen 1.4% in April, but has still returned about 2% year-to-date. It sports a 12-month yield of 7.38% amid a scarcity of good income opportunities, which remains the key reason the newly risk-tolerant have flocked to junk bonds in the first place.

Portfolio managers such as Reed Choate, who buys and sells the ETFs for clients at investment boutique Neville Rodie & Shaw, view the recent weakness as a buying opportunity. "My outlook hasn't changed in the past week, and it's probably not going to change in the next quarter," says Choate. "It is an attractive asset class, with the current [low] default rates."

At the same time, torrential junk-bond issuance and robust investor demand can't keep up forever.

One coming test: earnings season. Over long periods, corporate earnings growth needs to turn higher to support continually stronger high-yield performance, notes the Leuthold Group's Chun Wang, in a report. That's a tall order after the steep earnings run-up since the financial crisis. For an asset class that gets tossed out when macroeconomic worries take center stage, this shapes up as just one more test of just how hungry yield-seeking investors are.

Here's another gauge, which could be bullish or bearish: ETF providers are launching a bevy of new products in this area.

The past few weeks' new offerings include the iShares Emerging Markets High Yield Bond Fund (EMHY)—a fund for the intrepid, with its 21% Venezuela weighting—and the Market Vectors Fallen Angel High Yield Bond ETF (ANGL), holding issues from the likes of J.C. Penney (JCP) and Frontier Communications (FTR). Investors who go far afield for yield will show up for such funds.

INVESTORS WHO BUY THE STOCK market's dips shouldn't forget the niche between small-capitalization stocks and large ones. Mid-caps offer a pop in bull markets, but with less recourse than small-caps to tiny companies. They usually don't offer much in the way of portfolio diversification, but many mid-cap companies are more domestic than the biggest stocks. That could prove important this year. If the U.S. recovery keeps leading the globe, mid-cap exchange-traded funds will benefit.

The year has already been kind to mid-sized stocks, with the S&P Mid Cap 400 rising 13.1% in the first-quarter, powered by components such as energy-drink makerMonster Beverage (MNST), up 36% through Wednesday, and data-center operatorEquinix (EQIX), up 54%.

The index's quarterly return beat the Russell 2000 index by a percentage point, upsetting the expectation that smaller stocks would do best when traders take a "risk on" attitude. It beat the large-cap Standard & Poor's 500-stock index by roughly the same amount.

The performance versus large-caps is particularly impressive given that Apple(AAPL) added 11.5% to the S&P 500's quarterly return, according to S&P analyst Howard Silverblatt.

By at least some historical standards, mid-caps are reasonably priced. Credit Suisse small- and mid-cap equity strategist Lori Calvasina points out that the Russell MidCap Index components' one-year forward price/earnings ratio is right around the long-term average of 15. That suggests room to run, even as both small- and mid-sized stocks look pricey versus large-caps.

The $10 billion iShares S&P MidCap 400 ETF (IJH) and the $10.2 billion SPDR S&P MidCap 400 Index ETF (MDY), each up about 9.5% this year through Wednesday, are the field's neck-and-neck leaders, but they've been joined over the years by direct competitors and variations on the theme.

There's the $3.5 billion Vanguard Mid-Cap Index Fund (VO) and its tiny expense ratio. There's the $335 million WisdomTree MidCap Dividend Fund (DON), which has a 30-day SEC yield of 3.25%, and the $321 million First Trust Mid Cap Core AlphaDex Fund (FNX), which ranks and slices the S&P mid-cap index by factors such as book value and cash flow versus price. All data are from industry-tracker XTF.com.

For value investors, S&P Capital IQ's picks include the $930 million Vanguard Mid-Cap Value Index Fund (VOE), whose biggest sector weighting goes to financials, and the $6.6 billion iShares Russell Midcap Value Index Fund (IWS), with a healthy dose of financials and cyclical consumer stocks. Mid-cap value stocks have enjoyed a slightly stronger performance versus growth over the 10 years through December, according to Morningstar.

This is a decidedly contrarian trade: ETF investors have been yanking money left and right from the biggest U.S. mid-cap funds. But for patient investors, the conditions that made this niche advantageous are still in place.