Junk bond funds are continuing their winning ways in 2010 while popular stock averages have only minor gains, if any. Bond defaults, which can be a major problem in difficult times, have been limited and low interest rates have made using borrowed funds to increase bond holdings very profitable by increasing net investment income. Record low rates on Treasury debt has encouraged investors to look for higher yields creating more demand for junk bond funds. But all is not well.
During difficult times, yields on junk bond funds soar creating problems for junk bond funds. Higher yields bring lower prices for junk bonds in their portfolios. Interest expense on borrowed funds soars, squeezing net investment income for stockholders. Basically the world for junk bond funds pretty much collapses as it did around 1990 and in 2000.
Low interest rates, as is the case now, sound good but bring new problems. The positive carry from lower borrowing costs for financing bond investments is favorable. However when bonds mature (or are redeemed early), that money is reinvested in new bonds with lower rates reducing stockholder income. As a result, dividend cuts have been common at junk bond funds in the last year. However, stock prices have been rising reducing stockholder yields. 8-10% yields on junk bond funds are common. Because of extraordinarily low yields on the 10 year Treasury bond, the yield spread (difference) between the Treasury and junk bond yields is roughly 6-700 basis points, above a yield spread of around 450 basis points in good periods for junk bonds. Because this spread is much greater than at its narrowest, glory days for junk bonds may continue for some time.
In the middle of the 1990s and middle of this decade junk bond funds did well with yields around 8-9%. So present conditions could last for a considerable amount of time. But risk persists. When the economy recovers, higher interest rates will change junk bond fundamentals for the worse. Investors will demand higher yields and bond prices will fall. Net investment income will be compressed when interest expense on borrowed funds increases. But for the time being, low short term rates will keep demand strong for junk bonds and their funds.
Disclosure: No position