Don’t know what to make of the junk-bond market? Join the club.
One month, dollars are flooding into junk-bond mutual funds and exchange-traded funds. The next month, dollars are pouring out the opposite direction. Consternation is nothing new for this part of the market: Junk bonds are essentially loans made to companies with poor credit ratings, and they have to offer relatively big yields to attract investors. But skittishness has been particularly high, with $9.3 billion fleeing junk-bond funds in December, only for $9.6 billion to go right back in two months later.
Since then, flows have continued to be erratic into and out of junk-bond funds, which are also called high-yield bond funds, and several factors worry investors. The biggest is the threat of rising interest rates, which would knock down the price of all kinds of bonds. Last year’s plummet in the price of crude was also a big scare because oil producers make up a big part of the high-yield market.
Even with all the jitters, junk bonds have produced better returns this year than most other parts of the bond market. The average high-yield bond mutual fund has posted a return of 3.7 percent, compared with 1 percent for intermediate-term bond funds. If interest rates continue to rise gradually and if the economy avoids a recession — and granted, those are significant ifs — many strategists say junk bonds can continue to outperform the rest of the bond market.
“Right now, you’re getting paid for the risk of owning high-yield debt,” says Jim Kochan, chief fixed-income strategist for Wells Fargo Funds Management. That hasn’t always been the case, he says, citing periods when junk-bond yields weren’t high enough to make up for their riskiness, such as before the Great Recession and last summer. “If the high-yield market gets too expensive, like it was in 2007 and in June of 2014, it’s due for a correction. But it’s not that expensive now.”
To judge whether junk bonds are expensive, one factor to consider is how much more interest they pay over high-quality bonds. Yields for junk bonds are generally around 6 percent today. That’s not as much as they have been historically, but they’re still comfortably above what high-quality bonds are paying.
Because of that cushion, Kochan and others say high-yield bonds can better withstand a gradual rise in interest rates. Rising rates drag down prices of bonds that have already been issued because their yields suddenly look less attractive.
Prices for junk bonds would also fall as rates rose, but the increased income that they pay could help protect total returns. And given how wide the gap is between the yields of junk and investment-grade bonds, the cushion has room to shrink. If that were to happen, price drops could be less severe for junk bonds than for investment-grade bonds.
Defaults, another traditional fear for junk-bond investors, also look relatively benign for now. The default rate is below 2 percent, as companies have refinanced their debt and earnings growth means they have enough cash to make good on their bond payments.
If high-yield bond prices start to tumble, there’s a concern that the market will become illiquid.
