Junk Is Looking Less Junky

Lending money to the riskiest borrowers is starting to be a bit more profitable for investors willing to take on the risk. By definition, high-yield bonds are those issued by firms with less-than-investment grade credit ratings. Typically, junk bonds are rated BB or lower by Standard & Poor’s and Ba or lower by Moody’s. There is a lot of grey area within the ratings, but the basic idea is that some risk of default or issues could prevent payback of the bonds. As a result, investors demand more compensation for lending firms this money and, with that, junk bonds yield in excess of investment-grade corporates and treasury securities.

Normally, that is how it’s supposed to work.

However, as the Fed cut rates during the Great Recession and kept rates low through the pandemic, investors have clamored for yield and returns any way they could get their hands on. The end result is junk bonds were bought heavily and yields spent much of the last decade or so at historically small levels.

But with the Fed raising rates, junk bond yields are moving back to more normal levels. Investors have simply fled risk considering that safe assets like treasuries and cash are now paying close to 4%. According to Morningstar, ETFs within its high-yield bond category had net outflows of just under $17 billion this year, through the end of September. Those outflows as well as individual bond selling and junk bond mutual fund outflows have pushed yields up substantially.

The effective yield on the ICE Bank of America US High Yield Index is now 9.4%. That’s up from a meager 4.2% recorded in January of this year.

Be sure to check our High Yield Bonds page to explore all the relevant mutual funds and ETFs.

That over 5% worth of difference is pretty significant when it comes to historical measures and opportunity in high yield. The key is the so-called credit spreads. Basically, you’re looking at the additional yield of a bond versus a 10-year Treasury bond. That’s much more you’re being compensated for holding the riskier asset over the safety of a U.S. government bond.

Over the past 40 years, the average spread between holding junk bonds over a 10-year period has been about 4.8%. Right now, the 10-year is yielding just under 4%. Right now, investors are getting 5%+ in compensation to hold junk. And it turns out, that’s a great spread.

Because junk often trades at discounts to par value—as investors want to be compensated for risk—there is a bit of capital appreciation potential built into many of these bonds when they are repaid. With that, they are similar to stocks in terms of returns. It’s more about total returns. And it turns out this 5%+ spread is right at the beginning of the sweet spot that has provided great long-term returns for investors in the sector.

Investors may actually see those returns come to fruition. For one thing, the economy is still grinding forward. And while recession risks are growing, investors may have priced too much risk into junk, as evident by the spreads. Rating agency Fitch predicts that junk defaults will only hit 2.5-3.5% next year and 3-4% in 2024. S&P has a similar prediction. That is roughly in line with the 21-year historical average of 3.8%.

At the same time, the Fed has indicated it may pause the pace of rate hikes as inflation has continued to drop. That’s bullish for risk assets like junk and could lead to higher returns.

Given the opportunities in junk and the potential for both capital appreciation and higher yields, investors may want to consider adding some high-yield debt to their portfolios. Because junk functions as a total return element and has a similar volatility to equities, it’s best to think of them as a portion of that sleeve in a portfolio. This is not to replace an allocation to treasuries or cash. Financial planners recommend only about 5-7% of a portfolio in junk.

You can certainly buy individual bonds. However, given the potential for defaults, a broader mandate may be better.

The iShares iBoxx $ High Yield Corporate Bond ETF (HYG) is the big boy on the block with nearly $18 billion in assets and tracking over 1,200 bonds. With HYG, investors pick up a hefty 8% yield, plenty of trading volumes, and low expenses. Another choice could be the SPDR Bloomberg Short Term High Yield Bond ETF (SJNK), which focuses on the shorter side of the junk bond market. Here, SJNK is paying well over 6% in yield.

Finally, fixed income is one area of the market where active management pays off. Thanks to real credit research, active managers can find the best bonds at the biggest discounts to their values/cash flows. Mutual funds like the PIMCO High Yield A (PHDAX) or Fidelity Focused High Income Fund (FHIFX) can be used to take advantage of this fact.

With rates rising, yields on high-yield bonds have hot levels that have historically made them good buys for investors. Right now, investors are getting a good deal on junk bonds that could lead to a strong total return over the next few years. With that, investors may want to grab the opportunity.

Take a look at our recently launched Model Portfolios to see how you can rebalance your portfolio.