Time To Exit Junk Bond Funds?

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Includes: HYG, JNK
by: Dave Dierking, CFA
Summary

Junk bond funds have outperformed other bond classes and maturities over the last five years but will the good times end once interest rates begin to rise?

An improving economy as we've seen with stronger job and wage growth could improve the ability of companies to repay their debt.

Rising interest rates could ultimately make junk bond yields look less attractive.

The struggling energy sector has been particularly rough on the junk bond group.

As the Fed seems poised to raise interest rates at some point during the remainder of 2015 high yield bond funds and ETFs have enjoyed a solid run over the last several years when compared to other Treasury and corporate bond funds. Over the past five years, junk bonds funds like the iShares iBoxx High Yield Corporate Bond ETF (NYSEARCA:HYG) and the SPDR Barclays Capital High Yield Bond ETF (NYSEARCA:JNK) have outperformed their investment grade counterparts across all durations.

Junk bond funds have been increasingly popular among yield seekers looking to do better than the measly yields offered by Treasuries and CDs. But as the economic landscape begins to shift it's worth asking the question if junk bond funds have seen their best days. The free money period looks like it's going to be slowly coming to a close and so to may the comparatively solid returns offered by high yield notes.

There's evidence pointing in both directions so it's worth examining the major ideas one by one.

Junk bonds could correlate more closely to a stronger stock market and economy

The argument that high yields trade more like stocks than bonds could be viewed as a positive sign for their outlook. The stock market has had quite a run over the last three years and while valuations are almost certainly stretched there's not much evidence to suggest that a huge correction is imminent. That's not to say that the straight line up should be expected to continue but the environment could be conducive to high yields continuing to outperform other bond funds.

The economy could be in a similar spot. While GDP has been weak overall job growth and wage growth have been improving. Additionally, the JOLTS report that was issued last week showed that the number of open jobs advertised at the end of April - 5.4 million - was the highest number in the 15 year history of the survey. The government also indicated 280,000 jobs created in May. Even the unemployment rate which ticked up slightly could be an indication that job seekers could be reentering the marketplace.

A stronger economy could indicate an improved ability for companies to pay off their debt making junk bonds attractive. The Fed seems to think that the economy is improving enough to warrant higher interest rates and economic growth could lead to a positive environment for junk bond performance.

Higher interest rates could make junk yields less attractive

Junk bond funds and ETFs are offering current yields in the 5-6% range. Those yields looked especially attractive when the 10 year treasury note was yielding just 1-2%. The 10 year note is now yielding 2.4% and could soon be heading towards 3% again. An increasingly narrowing yield gap could make the risk/return tradeoff of junk bond funds less attractive.

Net outflows in junk bond funds have been increasing in the last several weeks as bonds in general have been selling off - an indication that investors could be viewing fixed income investments as less attractive in the face of rising rates.

Junk bond default rates are rising

The default rate in junk bonds climbed to its highest level in almost 6 years last month but we have the flailing energy sector to thank for that. Energy and mining accounted for 93% of all defaults in the 2nd quarter. Roughly 15% of the high yield universe comes from the energy sector so weakness in this area of the economy is having a significant effect on the overall group. Conversely, it means that the rest of the high yield universe is performing well. If you can stay away from energy the risk exposure to junk bonds could be much more limited.

Conclusion

We've been in a prolonged period where taking risk has been rewarded but the imminent rising rate environment could be the catalyst that reverses that trend.

A stronger economy should help junk bonds but I believe overall that riskier investments will begin falling out of favor as investors seek safer alternatives like treasuries, defensive and health care stocks. High yields exposure to energy could further limit upside. While energy prices look to have stabilized $60 oil is squeezing the margins of many companies and many rigs are still sitting idle.

Junk bond funds may have helped boost income seeking investors' returns over the past couple of years but now might be the right time to take some of those chips off the table.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.