Earlier this month, the yield on the average junk bond dropped below 6% for the first time ever. Because of this, many investors think that yields can't go any lower and that interest rates will reverse in 2013.
Here are four reasons why they are wrong:
Reason Number 1: Junk bond credit spreads are not anywhere near all-time historical lows.
In addition to the interest rate a particular type of bond (i.e., high yield, investment grade, etc.) is paying, bond traders will look at how that rate compares to Treasuries. This comparison enables traders to understand if a category of bonds is expensive or cheap given the current level of overall interest rates.
The chart below shows the difference in yield between the average high yield bond and a Treasury of the same maturity. This is what is known as the high yield credit spread.
As you can see from the chart above, while junk bond yields are at all-time lows, the high yield credit spread is nowhere near an all-time low. In fact, there were two extended periods of time since 1996 (which is as far back as the Fed's data goes), that the high yield credit spread was around 2.5%. This means at its current level of 5%, the high yield credit spread would have to drop another 2.5% before hitting a new all-time low.
Reason Number 2: Corporate Default Rates are near an all-time low
As you can see from the below chart, the average default rate on corporate bonds is around 4%. That compares to the current default rate of around 1.1%. So, while junk bond yields are at historic lows, so is the corporate default rate.
Reason Number 3: Yield-starved bond managers are going to start to leverage up.
This one I got from a recent presentation by bond guru Jeffrey Gundlach. In his view, the junk bond market is not yet in a bubble. Normally, a bubble is partially caused by investors increasing their leverage, which has not yet happened. He does think, however, that bond managers are going to start adding leverage to try and juice whatever yield they can out of this low yield environment.
When this happens, it will have the same effect as if a lot of new money and demand were coming into the market. While this will likely inflate a junk bond bubble in the future, it is likely to send yields even lower in the near term. A recent article in The Wall Street Journal confirms that this is already starting.
Reason Number 4: Everyone thinks there is a bubble in junk bonds.
Learn Bonds publishes a piece called "The Best of the Bond Market", where we link to all the best bond market stories from around the web each trading day. There have been so many stories about the "bubble in junk bonds" that I have had to tell the writer to start leaving some of them out. If we included them all, then half the stories in the piece would be the same story calling for a bubble in junk bonds.
From my experience, when everyone thinks a market is going to go in one direction, that market has a nasty habit of heading in the exact opposite direction.
The two largest bond ETFs that track the junk bond market are the iShares iBoxx $ High Yield Corporate Bond ETF (HYG) and the SPDR Barclays Capital High Yield Bond ETF (JNK). For more on how to invest in individual junk bonds and more, see our free guide here.