High-Yield Bonds: Do Current Risks Outweigh Returns?

Includes: JNK
by: George Putnam

A high-yield bond (aka junk bond) is a corporate bond rated as below investment grade, typically meaning it has a Standard & Poor's credit rating of BB or lower. High-yield bonds typically pay a higher rate of interest than investment grade bonds, and they also carry a higher risk of interest or principal default.

From time to time, I comment on these high-yield bonds because I think they may be of interest to turnaround investors for several reasons. While they are called bonds, many high-yield issues have return--and risk--characteristics closer to stocks than to other fixed income instruments. Also, many companies that issue high-yield debt are in the process of turning around, or at least trying to do so. Some high-yield issuers don't make it, file for Chapter 11 protection and eventually provide interesting distressed bond or post-bankruptcy stock opportunities.

Most recently, I have urged caution for investors interested in these high-yield bonds. While our worst fears did not materialize last year, high-yield bonds performed less well in 2013 than they did the year before. They significantly underperformed stocks; however, with a return of 7.4% for the year (as measured by the BofA Merrill Lynch High Yield Index), junk bonds were one of the best-performing sectors in the bond market.

I still have concerns about the high-yield market, and the passage of time has only made those stronger. My greatest concern is that defaults, which have been at very low levels for several years, will begin to increase soon. As the graph below shows, periods of strong high-yield issuance are usually followed by periods with a significant number of bankruptcies and defaults.

We've seen several years of record-breaking issuance, which suggests that a new bankruptcy wave may be just around the corner. With the typical junk bond currently paying a yield of only around six percent, I believe that bondholders are not being compensated for the increasing risk of default.

Another risk for high-yield bonds (as well as for other types of bonds) is that interest rates will continue to rise. As rates rise, bond prices will fall--perhaps quite sharply. When the Federal Reserve announced in June 2013 that it was beginning to consider tapering its bond purchases, fears of rising rates caused a sharp decline in the high-yield market. Bond prices recovered quite quickly when the Fed softened its tone, but that may not happen the next time there is an interest rate scare.

While it's not certain that either of these risks will come to fruition in 2014, I feel that the longer the current boom in high yield continues, the greater the risk of negative surprises. As noted above, at current low yields holders of junk bonds are not being paid enough to take on these risks.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.