Junk Bond Funds Face Challenges in 2011

| About: SPDR Barclays (JNK)

Junk bonds are having another good year after a record year in 2009. Stock prices of funds are 5-10% higher combined with nearly 10% in dividends. However, stock prices pulled back 3-5% in Q4. Mutual funds investing in junk bonds are also higher YTD, including gains of roughly 1% in Q4. There were 3 pullbacks this year for junk bonds. The first 2 were in May and August, when risk aversion increased causing investors to sell high risk debt. The third decline has been in Q4 while the Federal Reserve has been buying Treasuries. Dividends were flat to lower from reduced investment income.

Speculative-grade issuance of junk bonds was strong in 2010, having reached $269 billion by September, surpassing the previous annual record. September and October were the 2 busiest months for new junk bond offerings on record when borrowers sold $73 billion of debt. Offerings slipped in November, but December is expected to be a busy month as these bonds remain the only game in town for investors demanding high yields.

Most bonds are valued at par or premiums, a sign of strength for high yield debt. But today's yields can only be described as moderately high. The average yield on junk bond debt is 8%, a 400 basis point premium over investment-grade bond yields and a 460 basis point premium over the 10 year Treasury bond. Absolute yields are at low levels by historical standards, as are premiums over the 10 year treasury debt. However, periods of low interest rates have lasted for months, even years, as in the middle of this decade (concluding this week). High defaults reduce income, but they have not been a significant problem during the recession and are currently running at the lowest levels in 3 years.

Junk bond funds face 3 stiff challenges in 2011. First, many times, reinvested money from maturing debt is reinvested in bonds with lower coupons (yields). Secondly, most closed end funds borrow against equity to earn additional income from positive carry (interest earned exceeds interest expense). However, interest rates have climbed in the last two months, raising the cost of borrowed funds. Reduced net investment income brings dividend cuts and leverage hurts when interest rates rise. A good example is that stock prices of closed end funds have sold off in Q4 while open end (mutual) funds with no leverage have inched higher. A third challenge is intangible. Many funds buy foreign sovereign debts or bonds in foreign companies. Sovereign European debts were significant in the severe setback for stock and bond prices in May and those concerns are rising again. In addition, emerging market debt has yet to be tested. The effects of QE2 are blurry so far. Its purpose is to keep interest rates low. But rates have shot up despite those purchases.

The primary source of gains on junk bond funds is net interest income earned. In 2011, dividends can not be expected to increase (similar to 2010). Instead, there will be modest reductions from lower net investment income and higher interest expense (interest expense has been benefiting from unusually low interest rates on borrowed money). Fund prices may continue struggling as they have been following the sharp rise on Treasury yields. Recovering economies around the world should keep debt defaults low, but 8% yields on junk bond funds may not be enough to exceed price declines, producing limited or even negative rates of return in 2011.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.