High Yields on Junk Bond Funds Still Attractive in Low-Yield Environment

| About: SPDR Barclays (JNK)

I just had a meeting with a fund manager for a prominent group of high-yield (junk) bond funds and he was optimistic about the future, even with higher interest rates approaching. These funds yield 8+%; low by historical standards, but high in today's world of low interest rates. The yield spread over the 10-year Treasury bond is about 450 basis points, again low by historical standards.

Junk bond funds came through the financial meltdown in good shape because they primarily invest in corporate borrowings. That collapse was caused by investments in risky mortgages, not corporate debt. Defaults are a major expense for junk bond funds and default rates have been low. He said defaults are running at 1%. I think his numbers are too low. Bloomberg recently reported that defaults were running at 3%, the lowest level in years. Either way, defaults are very low.

Higher interest rates are coming, but will not necessarily bring higher interest rates on junk bonds, which are not directly related to those on quality bonds. However, the spread between the two will narrow -- a cause of concern for bond holders. Funds can cope to a limited degree by adjusting maturities and purchasing more foreign bonds with higher yields. Managers evaluate foreign bonds with higher yields in addition to U.S. debt.

Implications for leverage are also of concern. These funds typically use leverage (borrow against equity) to increase net income. With current low interest rates, interest expense is virtually zero. Higher interest rates will raise that cost which will squeeze net investment income, resulting in reduced dividends.

The funds also have problems reinvesting funds from maturing bonds (or when bonds are paid off early). That money can purchase new debt with lower interest rates, and net interest income is reduced, which results in dividend cuts.

Junk bond fund investments have done well in the last 10 years, assuming dividends were reinvested. I checked mine. Over that period, investments have roughly doubled. Since December 2007 (when the recession began), these investments have risen roughly 25%. Gains are attributable to more shares.

Prices are back to where they were before the financial meltdown, when yields exceeded 25%. But stock prices are below record highs, which were based on higher dividends that will never be restored. This year, gains are continuing. In Q1 stock prices rose 5%.

Pursuing high investment yields in this low-rate environment is difficult. MLPs yield 6%, REITs yield 3-5% (and less) and 5% yields are available on telecoms and utilities. A few Dividend Aristocrats and Dow stocks, McDonald's (NYSE:MCD) and Intel (NASDAQ:INTC), yield above 3%. Junk bond fund yields look good when compared with the competition, even though present yields are essentially at record low levels. Periods with these yields have lasted for years, such as in the 1990s and in the last decade. Junk bond funds offer the highest competitive yields and have good track records, while some quality companies have stumbled in recent years.

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