More and more investors have been attracted to the junk bond market as the bank interest rates are artificially low and the yields on the Treasuries trails inflation. SPDR Barclays Capital High Yield Bond ETF JNK, which tracks the widely followed Barclays Capital High Yield Very Liquid Index, has seen its cash inflow of almost $5 billion since the beginning of 2010.
Amid a continued drop in dividend payout, some financial experts warn there may be bubbles in the junk bond market. One of the arguments that buttresses the claim is that the yield spreads have dropped so dramatically that current returns won't be able to justify the risks investors take in the junk bond market. Before we jump to any conclusions, let's do a reality check.
The most recent recession forced the Fed to lower the interest rate and keep it low for a few years. The ultra low interest rate has given bond issuers more breathing room. New issues can bear lower dividends given the same or lower yield spreads. Even worse, issuers can also repay the callable bonds, pushing investors into lower yield issues. On the credit risk front, the overall default rate of junk bonds has dropped from the peak in 2009 so much so that bond issuers deem the decrease in dividend payout is in line with credit market conditions.
The following chart has shown that the dividend for JNK dropped by 42% in 36 months.
The yield has almost shrunk 45% since October of 2009 as unabated enthusiasm kept supporting the price in spite of the continuous drop in dividends throughout the 36 month period.
More prominently, the yield spread between JNK and 10 year T-Note has decreased from 880 bps in October of 2009 to 502 bps in September of 2012.
One of the reasons behind this is that the overall default rate for the high yield bond market has steadily improved since mid 2009. The diminishing yield spread mirrors the change. In the summer of 2009, the HY default rate topped out at 14%. Now it stands around 3%. Today, owning the JNK ETF may have lower risk than doing it in 2009. The yield spread is still above the default rate plus some premiums.
On the other hand, the current low yield environment may continue to disappoint income-hungry investors. From the top 10 holdings of JNK, we found most of the issues are double B or single B rated by Moody's. In order to enhance the yield, investors have to sacrifice quality of issues. By moving down aggressively to single B and even highly speculative C issues, the yield will be raised so long as investors stand ready to face the default risks.
|US852061AK63||Sprint Nextel Corporation||Telecom||Senior Debt||9% Guaranteed senior unsecured notes, due Nov 15, 2018||BA3||BB-|
|US404121AC95||HCA, Inc.||Health Care||Senior Debt||6.50% Senior secured notes due Feb 15, 2020||BA3||BB|
|US319963BB96||First Data||Industrial||Senior Debt||12.62% Senior unsecured notes, due Jan 15, 2021||CAA1||B-|
|US29269QAA58||ENERGY FUTURE/EFIH FINAN||Utility||Senior Debt||10% Senior secured notes, due Dec 1, 2020||CAA3||B-|
|US796038AA56||Samson Investment Co||Oil & Gas Services||Senior Debt||9.75% Senior notes due Feb 15, 2020||B1||B-|
|US413627BL36||CAESARS ENTERTAINMENT OPERATING CO||Consumer Services||Senior Debt||8.71% Senior notes due Jun 1, 2017||B3||B|
|US451102AH03||ICAHN ENTERPRISES/FIN||Financial||Senior Debt||8% Senior unsecured notes due Jan 15, 2018||Ba3||BBB-|
|US12543DAL47||CHS/COMMUNITY HEALTH SYS IN||Health Care||Senior Debt||8% Senior unsecured notes due Nov 15, 2019||B2||B|
|US29977HAA86||EP ENERGY/EP FINANCE INC||Industrial||Senior Debt||9.375% Senior unsecured notes due May 1, 2020||B2||B|
|US676253AC15||OFFSHORE GROUP INVST LTD||Financial||Senior Debt||11.5% Senior secured notes due Aug 1, 2015||B3||B-|
Data Source: Zumlon Technologies LLC
However, what investors really should do is to look forward to future default rates among issues. Unfortunately, that does not bode well as recent overall HY default rate has begun to edge up near the standard threshold of 4%. Our model has detected some unnerving upward pressure of the overall default rate and expects the rise may continue.
As a predictive indicator, if it keeps on marching northwards, another recession may be looming. Current investors may still be able to load junk bond issues, but the exit strategies have to be well planned ahead.
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.