High Yield Bond Rally May Be Coming to an End

Includes: CMU, COY, HYG, JNK
by: Avi Morris

Junk (high yield) bonds are having their best year in history. At the start of 2009, risk averse was the popular theme in plunging stock markets. Junk bond prices plummeted sending their yields over 25%. Since early March, stocks roared back (popular stock averages are typically up 50%) and the rebound in junk bonds has been even more dramatic. Risk is being embraced and rewarded.

However, Treasuries rallied when risk averse behavior became the motivating force in the markets early in 2009. That rally cut the yield on the 10-year Treasury to only 2%. Then junk bonds rallied and Treasuries sold off sharply. The yield on the 10-year Treasury soared, touching 4% two months ago. In the last 2 months, Treasuries rallied again taking their yield back below 3¼%.

Meanwhile, in the last two months junk bonds extended their rally, bringing their yields even lower to around 11-13%. But the junk bond rally has flatten remaining at or near 2009 highs in the last 2 weeks. This could be signal for the end of the 2009 rally in junk bonds.

Yields on junk bond funds are not too much higher than their lowest yields in the best of times, around 9%. I recently met with 2 money managers for junk bond funds. One was very optimistic about the outlook for junk bonds primarily based on an expected strong rebound for the US economy next year (with a growth rate of 3+%). A high growth rate would take care of many bond default problems. The other manager was much less optimistic about the future. He is concerned about current high default rates on junk bonds, worried that high default rates may continue or even rise.

The disconnect between the recent rise in prices for Treasuries (quality bonds) and junk bonds is significant and can not last. I worry about a sluggish recovery for the economy keeping default rates high for junk bonds, requiring higher interest rates than current (which are only slightly above the lowest rates in the best of times). Higher interest rates will require lower junk bond prices.