Junk Bond Funds: Caution Is Key

In the first half of 2009, junk bonds had one of their greatest rallies in history. At the beginning of this year, fear in the investment world was running high. Investors responded by selling risky investments, such as high yield (junk) bonds, using that money to purchase safer investments (i.e. Treasuries).

As a result, yields on Treasuries dropped to near record lows when investors pursued safety at any cost. The 10 year Treasury bond annual yield had plummeted to nearly 2%.

Then investors relaxed and became more comfortable with the concept of accepting risk for high yields. At the start of 2009 when few wanted to accept any risk, yields on junk bonds shot up to 20-25% with a yield spread over the 10 year Treasury yield in excess of 2000 basis points.

These are levels never before seen. Stocks, and, especially junk bonds, were bid up to lock up high double digit yields because of a growing acceptance of risk. Junk bonds continued to rally while the stock market had a great 3 month rally. From astronomical levels, yields on junk bonds plunged to around 13% or roughly 1000 basis points above the 10 year Treasury.

While yields and yield spreads are still high relative to traditional standards, the recent decline in yields are pushing them near levels of more traditional times. In better times (such as a few years ago), yields on junk bonds were around 9-10% or roughly 450 basis points above the yield on the 10 year Treasury (around 4-5%).

Now the Treasury is borrowing record amounts of money and Congress is proposing even more spending programs which will add to future government borrowings. Present Treasury yields are vulnerable, more borrowings may increase Treasury yields. The economy is expected to remain weak for months which can bring on many more defaults on high yield bonds. Junk bond funds gained 23% in the first half of this year, that pace can not continue.

For those interested in investing in junk bond funds, caution may be the best course of action, or to "await developments."

Disclosure: no positions

Comments

[Larry House:]

You are spot on. Junk bonds should be viewed more as equities in risk, and they can correct just as quickly and violently as stocks. Junk bonds have responded to "green shoots" too, but they are anything but safe at this time. S&P predicts that the zenith of the junk bond default rate is still ahead of us--around 15%. That rate will scare the pants off those who hold junk bonds.

Jul 07 12:06 PM

[donzelion:]

Good article, and a quick glance at a 1-year chart confirms the remarkable correlation between JNK and mainstream equity ETFs like SPY so far. I wonder if that correlation will hold. If the junk bonds default en masse, many equities should be hammered along with them...

I like how JNK has performed in my IRA so far this year, but I keep a stop loss in place should it ever drop significantly in any given month. I'm up about 10% on my position so far, but I see it as a "hold until the 11th hour" position, and want to keep an exit handy.

Jul 07 05:18 PM

[BGRT:]

I agree somewhat with this article. Take caution in buying but do not necessarily avoid junk at this point. JNK@35 is probably the level at which risk becomes greater than reward. I don't particularly understand how SPDRs is calculating the JNK yield, but at the 40 cent per month per share distribution which has kept up for the last 5 months, this fund is currently yielding 14.3% and presumably a higher yield to maturity. By this calculation, yield is at a minimum 1100 bps over 10 year treasuries and the JNK average maturity is 7.3 years. Furthermore, unlike equities, secured junk bonds don't go to 0 when an issuer defaults. Senior secured investors would probably get 30 cents on the dollar according to Moody.

So, I would say be careful but the valuation is still not too bad.

Jul 07 07:42 PM

[Randy Durig:]

Junk Bond Quotes and Fiduciary Mutual Fund Rankings:
investment-income.net/...

Jul 14 01:24 AM