For fixed-income investors, the last year has really ‘reset’ a lot of the bond landscape. After a decade of zero-interest rate policies from the Fed, today’s bond market is looking a lot more like its historical norms. In that, a variety of income bonds are now offering tasty yields.
And that includes junk bonds.
These days, debt issued to the riskiest borrowers are offering yields close to 9%. While there is some risk, other data suggests that now could be a great time for investors to add a swath of high-yield bonds to their portfolios. And there are plenty of easy ways to do just that.
Don’t forget to check our Fixed Income Channel to learn more about generating income in the current market conditions.
A Bad Year for Junk
Like much of the bond sector, junk bonds have hurt the Fed and new monetary tightening policies. By definition, high-yield bonds—or junk debt—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. The basic idea is that some risk of default or issues could prevent payback of the bonds. As such, junk debt historically yields more than comparable Treasuries or investment-grade corporate bonds.
So, as the Fed raises rates, investors tend to sell junk and move into safer, now higher-yielding Treasuries or corporates. Why take the risk, when you can get 4–6% in safer fixed income assets?
The safety aspect also plays into the fact that when the Fed raises rates it’s because the central bank is trying to slow the economy. For lower rated bonds, economic duress increases default risk. Again, this sends investors out of junk and into safer alternatives.
The combination of these factors produced one of the worst years on record for bonds, junk in particular. The ICE BofA Merrill Lynch US High Yield Index—which tracks the performance of U.S. dollar denominated below investment-grade corporate debt—managed to finish the year down 15%.
Bargain-Level Bonds
With the dip in the bond market—junk included—yields have moved back to levels closer to historic norms. And in the case of junk, we could be in the sweet spot.
With the dip in price, the previously mentioned ICE BofA Merrill Lynch US High Yield Index is now yielding a juicy 8.25%. To put that in context, about a year ago, the index was yielding around 4%. But the real number to look at is the so-called spread, or the extra yield investors get for holding junk over U.S. Treasury bonds. Right now, the spread over Treasuries for junk bonds is around 5.11 percentage points. This is the first time since October that it’s been above 5 percentage points.
What’s significant about that number is that it seems to be in the sweet spot for long-term gains without a ton of default risk. For example, spreads were closer to 10 percentage points during the first months of the COVID-19 pandemic and over 20 percentage points during the Great Recession.
The spread also means there are some capital gains to be had. High-yield bonds often trade at discounts to par value because investors want to be compensated for their additional risk. This provides a bit of capital appreciation and, historically, the spread at 5 percentage points is the beginning of this sweet spot for gains. Investors get added compensation, but defaults still remain low.
And speaking of those defaults, we may be overestimating them today. Truth be told, balance sheets remain pretty healthy relative to historical debt/cash on hand levels. Second, the amount of junk debt maturing in the near term is low. According to Goldman Sachs, only about $106 billion of high-yield bonds are set to mature in 2023 and 2024. This compares to $881 billion in 2026 and 2029. Even a recession today wouldn’t create a credit crunch according to the investment bank. Many firms in the junk market are locked into lower rates for longer and won’t have to worry about raising funds now.
Making a Junk Bond Play
Given junk’s high yields, sweet-spot credit spreads, and potential to navigate the recession better than expected, fixed-income seekers may want to add a dose of high-yield bonds to their portfolios. Junk functions as more of a total return element, so investors need to plan accordingly. Given the size and scope of the junk bond market, adding them is easy.
You can certainly buy individual bonds. However, given the potential for defaults, a broader mandate may be better.
The iShares iBoxx USD High Yield Corporate Bond ETF (HYG) is the largest ETF tracking the segment and holds more than 1,200 bonds. This keeps default risk at a minimum. HYG is currently yielding a hefty 8.02% and features low expenses. The SPDR Bloomberg High Yield Bond ETF (JNK) is another low-cost and compelling choice to add broad index exposure to the theme. But there are numerous ways to hone in on certain aspects of the junk market such as credit rating or duration. For example, the Invesco BulletShares 2025 High Yield Corporate Bond ETF (BSJP) could be used to shorten duration risk with regard to interest rate policy.
Ultimately, the bottom line is that high-yield bonds are finally looking less risky than before. Investors willing to take the risk could be handsomely rewarded now that spreads are indicating lower defaults and yields are nearly 9%.
Take a look at our recently launched Model Portfolios to see how you can rebalance your portfolio.
