Junk Bond Funds With Lower Yields Will Keep Rising (For Now)

by: Avi Morris

Junk bond funds are having another outstanding year. Declining yields for Treasuries and their resulting price increases have been favorable for junk bonds. Investors looking for high yielding investments have been flocking to junk bonds and willing to accept or overlook their increased risks.

Junk bond funds are typically up 10+% YTD despite dividend cuts. Reductions in monthly dividends this year have been on the order of 10% but some funds have been able to hold monthly dividends flat. Yields have fallen to historically low levels, under 8% is common although some of the higher yield funds still offer 10% yields. Yield spreads of junk bond funds over 10-year Treasury bonds are around 550 basis points, moderate by historical standards.

Other high yielding investments have also done well. REITs, even though many have had to cut dividends, typically yield 3-5%, extremely low by historical standards. The Dow Jones REIT Index has almost tripled from its depressed lows 2 years ago. MLPs have been soaring to record highs at a time when few stocks, Apple (NASDAQ:AAPL) being a major exception, can make that claim. The Alerian MLP Index at over 360 has seen its yield fall to under 6¼%, approaching its lowest levels. Junk bonds funds have more than doubled from their lows 2 years ago when many yields were around 25%.

Loan defaults have been at acceptable levels for these funds, but there is a constant risk that a downturn in the economy can increase defaults. Low interest rates bring on a business risk that hurts net investment income. As loans mature or are refinanced early, that money is used to buy new loans with lower interest rates. To increase income, funds can raise leverage (borrow more) to buy additional bonds. The net spread between investment income and the cost of capital is a positive carry (favorable net income spread). Another way to increase income is to increase foreign loans, particularly in countries with greater risk. Over the short term, aggressive investing will help maintain dividends but investing in marginal bonds raises the risk levels of portfolios. While it is difficult to think about higher interest rates in today's economy, when they come, and they will eventually, heavily leveraged funds will suffer badly as they have in the past.

High prices for these funds are enjoyable. I know personally, all my positions are at record levels because of reinvested dividends and fund prices that are at roughly three year highs. Present conditions can last for several years as they did during the middle of this decade and the middle of prior decade. But the past has taught us that the end can be violent. As long as interest rates on Treasuries remain low, junk bond funds will remain in demand for their high yields even though they are only at moderate levels that barely reward investors for the added risk.

Disclosure: No positions

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