Two months ago I wrote, "Selling Begets Selling: Shorting Junk Bonds As Bond Market Dislocations Continue." My timing was not great. Shortly after, the major junk bond ETFs had a brief rally and then came back down to roughly the same level. I currently do not have any short positions related to junk bonds, but I continue to have a negative outlook as the bullish trend in junk bonds through May still seems to be in reverse. In this article, I will look at the price and spread dynamics of CCC, B and BB rated bonds as well as the key junk bond ETFs.
Outlook On Treasury Bonds
The 10-year closed today at a yield of 2.90% and a test of 3% seems likely. As long as the 10 year stays above 2.75% I expect it to continue to move to the 3.5% - 4.0% range. It may not get there in a straight line, but it seems like that is the general direction. As bond yields go up, bond prices go down
For more on my outlook on Treasury Bonds, please see:
- The Fed Minutes And Treasury Bonds: Focus On Forward Guidance, Not Tapering
- Disaster Scenario For Treasury Bonds: Is The 10-Year At 2.83% A Trigger Or Trap?
Rising Treasury yields are a negative for junk bonds. Most bonds trade at a spread to Treasury yields. Therefore, if the yields on Treasuries rise, then the yields on these other bonds should also rise to maintain the same spread. The spread could compress, but spreads are very tight by historic standards and I don't think they have much room to compress further.
I am expecting junk bonds yields to continue to rise. The rise in Treasury yields is causing a repricing across all asset classes and I expect the junk bond market to continue to feel the impact. I am not expecting a crash. Default rates are still very low and will probably stay low.
A rise in default rates could cause a crash, a rise in Treasury yields is causing a repricing.
Junk Bonds are rated BB, B or CCC (the latter being the most risky). Here is an update on the yields on each group of bonds followed by the spreads.
(Source for all bond yield/spread charts: Federal Reserve Bank of St. Louis)
Junk Bond ETFs
They are mostly focused on bonds in the BB and B range.
Since May 1, the JNK and HYG have been down. However, they held up better that the iShares Barclays 20+ Yr Treasury Bond ETF (NYSEARCA:TLT).
JNK data by YCharts
The Junk bond ETFs have shorter durations than TLT ETF, which helps explain why they have held up better.
Junk Bond Sentiment
The junk bond market is continuing to experience outflows. Reuters reported that junk bond funds had $2.3 billion of outflows last week.
I expect a continued rise in Treasury yields, which will likely be a negative catalyst for junk bond yields. The trend in junk bond yields has changed. Until May there was a trend of lower yield, but that has reversed. Despite the move in junk bond yields already, spreads remain very tight.
The real question for the junk bond market is whether these tight spreads can be maintained. Low default rates is an important factor supporting low spreads.
However, the repricing of all asset classes due to the rise in Treasury yields may have a negative impact on junk bond spreads. Also, I still don't think that junk bonds offer an attractive yield on an absolute basis. For a while everybody was chasing yield and running to junk bonds. At some point that may end and spreads could widen as a result.
Some investors need to be in bonds and junk bonds may represent a good option for them. However, for investors that do not have those restrictions, yields still seem too low.
Nonetheless, I am no longer short junk bonds. They have not been a good way to play my cautious/bearish outlook.
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