Are Junk Bonds About to Become a Victim of Their Own Popularity?

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In our current low-interest-rate environment, many investors are widening their search for more income by buying junk.

Junk bonds, that is.

More formally known as high-yield bonds – junk bonds have been on a tear lately.

With the Federal Reserve vowing to keep interest rates at or near zero through 2014, investors seeking higher-yield investments are eyeing junk bond exchange-traded funds (ETFs).

Investors dumped $31 billion into high-yield bond funds during the first quarter of 2012 according to research firm EPFR Global. That's almost four times the global demand for junk-bond funds in 2011.

Here's why.

Junk bonds are offering generous dividends at a time when most other bond investments aren't even matching the rate of inflation.

"Clients are essentially trying to replace the income they used to get from their government bonds," Hans Olsen, head of investment strategy in the Americas for Barclays Wealth, told Bloomberg News.

Indeed, one of the largest junk bond exchange traded funds, the iShares iBoxx High Yield Corporate Bond (NYSEArca: HYG) is currently yielding more than 7%, while yields on the 10-year Treasury note hover just above 2%.

But while robust demand and issuance for junk bonds is a sign of a healthy market, there are reasons for concern.

Junk Bonds: Default Rates Not the Whole Story

There's evidence that investors chasing income in the form of high-yield debt are taking on increased risk.

It's possible investors in high-yield debt are being lulled into complacency by low default rates. Corporate balance sheets haven't looked this good since the financial meltdown of 2008.

Global speculative-grade debt defaulted at a rate of 2.3% over the past 12 months, down from 2.6% from the first quarter of 2011, according to Moody's Investors Service. The ratings company expects the default rate to rise to only 3% by year-end — still a relatively low number.

Still, investors should be aware that junk bonds come with the full risk of the corporate entities that back them.

"We consider investing in high-yield corporate bonds to be similar to investing in the equities of companies with highly leveraged balance sheets," says Morningstar Inc. (Nasdaq: MORN) analyst Timothy Strauts.

"With increased leverage comes the increased probability of default and bankruptcy."

But the biggest risk for junk bonds may not be that the companies backing them might end up in bankruptcy. Even a major Black Swan-type event isn't likely to trigger a financial crisis on the magnitude of 2008.

Instead, what might be the biggest nemesis of junk bonds is their own popularity.

The prices of almost all bonds have catapulted up to extreme levels in recent years, driving yields to historic lows.

If global interest rates suddenly climb, junk bond prices – along with most bonds – would likely get clobbered.

"There is a lot of money rushing into this space right now," Paul Jacobs, a financial planner at Palisades Hudson Financial Group, told ETF Trends. "As quickly as it came in, you could see that money flow out."

In fact, investors have begun to show caution as doubts about the strength of the global economic recovery and new concerns over the Eurozone debt crisis have reemerged.

Junk bond mutual funds and ETFs saw net outflows of $1.3 billion in the first week of April for the first time in nearly five months, according to data from Lipper Inc.

"The massive withdrawal…continues a trend that has seen investors back away from the junk-bond market because of renewed fears about the strength of the global economy and about Europe's sovereign-debt crisis," Dow Jones Newswires reports.

Junk Bonds are Stock Market Barometer

Even if you're not a junk-bond investor, it's important to study and understand these recent developments in the high-yield debt market. The reason: They can serve as an early warning signal for trouble to come in the stock and bond markets.

High-yield bonds have been "great tools to help call major tops and bottoms," Chris Kimble at Kimble Charting Solutions wrote in an investment newsletter.

Investors right now need to answer two big questions, according to Shah Gilani, an investing expert behind Wall Street Insights &Indictments an insider's take on the markets.

  1. Are they just too late to the party to expect substantial returns?
  2. And will the smaller (lower-yielding) coupons being offered at this stage of the game cushion them if volatility increases because interest rates start to surge?

Stock prices could tank hard if leveraged investors who borrowed to increase the returns they get on junk debt are forced to dump positions and the stocks of the companies that issued them, Gilani warned.

Any meaningful jump in market interest rates, or a precipitous drop in stock prices, could be a signal to take profits in high-yield investments, he said.

At the same time, Gilani says it could be a great opportunity to buy some protection with "Puts" on theSPDR Barclays High Yield Bond ETF (NYSE: JNK).
Bottom Line: Now would be a great time to review your holdings and assess your personal risk tolerance against a market that's likely to remain volatile.

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