Last week was a difficult time for stocks, with the concern about raising the debt ceiling for US Treasuries. Junk bond funds, stocks with high yields, pulled back in sympathy.
Junk bond funds performed well in recent years. There have been 3 major downturns, in 1990, around 2000 and the financial meltdown in late 2008. Junk bonds plummeted during these downturns. In the first two, fund managers invested in bad bonds which suffered high default rates and dividends had to be slashed. The use of leverage made matters worse.
But 2008 was much different. Junk bond funds held up well when stock markets sold off during much of 2008. Then came the Lehman collapse in September. Stocks and junk bonds suffered substantial losses as risk averse became the popular driver for investors. In just a few months, yields on these funds soared from around 8% to record levels over 25%. By 2009 risk averse subsided, bringing a recovery. Below is chart for a popular ETF which gives the flavor of the selling and recovery. However, it understates the plunge in late 2008 when its maximum yield hit "only" 17%.
SPDR Barclays Capital High Yield Bond ETF (JNK)
Three years ago there was no logical reason for the collapse of junk bond funds beyond hysteria in the stock market. Dividends held up well with only limited cuts. Defaults were low and have even drifted lower since then. The chart above shows that JNK price has been flat, allowing investors to earn roughly 8% annually during a time of very low interest rates.
I just met with fund managers for popular funds and they are looking for a continuation of favorable trends in junk bonds (i.e. low default rates). But the chaos coming out of DC on the inability of the government to raise the debt ceiling is raising concerns for all debts and what interest rates are appropriate in these troubling times. The president just announced a temporary fix for the debt ceiling increase, but it uses Scotch Tape, which many (who will vote on the measure) don't understand. The vote, especially in the House, is considered at risk.
If passed, this won't be final or complete. The creditworthiness of US Treasuries will be at risk and remain in question. A reduction in the ratings for Treasuries will bleed through to all debts. Added risk could bring price declines, raising yields on all bonds. While the fundamentals for junk bond funds not have changed (default rates should remain low), larger risk averse forces could bring on more selling. Lower prices will be of interest to investors waiting for the opportunity to lock up higher yields. Those who bought junk bonds 3 years ago when rates were substantially higher, are still earning over 20% on their original investments.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
