Junk Bond Funds Extend Greatest Rally in History

| About: SPDR Barclays (JNK)

With a strong market for stocks in 2010, junk bonds are extending their greatest run in history. Many have doubled off their lows, a few have even tripled from severely depressed prices. I evaluated my bond funds. All investments are at record levels from reinvested dividends, helped with reinvesting over the last couple of years. But prices for the stocks will never reach new records, not with current dividends.

The major problem with the run up in prices is the corresponding reduction in yields. Junk bond funds yield less than 11%, some even less than 10% or 9%. Junk bond funds had yields under 9% in the best of times. However current yields, while comparatively low, are not a specific indication that junk bond prices will have to decline. Moderate yields on junk bonds have been common for several years.

The yield spread over the 10-year Treasury bond (reward for owning riskier debt) is around 600 basis points, a little higher than 450-500 spread spread in the best of times. But these are not the best of times. The yield on the 10-year Treasury bond has gone through exciting gyrations this week. The yield broke out of its recent range in the mid to high 3% area and touched 4%, the high last year. Today (April 7), the Treasury sold $21 billion of 10-year notes with "only" a 3.9% yield. Demand for the notes was so strong that in the after market notes closed at a 3.86% yield, for an enormous daily decline in yield of 11 basis points. Strong demand was encouraged by greater concern about Greek debt default and to a lessor degree comparable debts of other European countries.

The bull market for junk bonds faces 3 major challenges:

(1) Higher default rates
(2) Higher interest rates
(3) Foreign debt holdings

So far defaults have not been a large problem as in the past. But if the recovery stalls, there will be more defaults. The recovery must bring an improving job picture reasonably quickly.

Low short term rates will continue for an extended period, according to the Federal Reserve. But they will end and the best estimates are that short rates will start heading north after the elections (not that far away). High short rates should bring upward pressure on the long rates. Also a stream of massive government borrowings can pinch hard at any time. Higher short rates will also reduce investment income at junk bond funds. Many junk bond funds have leverage bond accounts, they borrow funds by using equity as collateral. The cost of this money is based on short rates (very low presently). This money is invested in junk bonds yielding 9-10% with the net income flowing to stockholders. That sounds good, but when the pendulum swings back everything goes wrong. Financing costs rise sharply (especially from these levels) as bond prices fall.

Foreign bonds with high yields are in many portfolios, so far they have not behaved badly. But they haven't been tested in difficult times. If there is a major failure, Greece is already getting a lot of attention, all foreign borrowings will come under greater scrutiny.

Junk bonds are simply stocks with very high yields and yields have been reduced sharply with this record rally. Buyers assume the recovery will continue which will spur greater demand for junk bonds and bring even lower yields. However, I feel the relatively low yields on junk bond funds are insufficient to compensate for the added risk of owning high yield bonds.

Disclosure: No position