by LearnBonds.com | September 17, 2012 8:00 am
Investing in a high-yield fund, also known as a junk bond, is called the chicken equity trade on Wall Street. You get almost the same return as stocks, but with less risk. … or at least that is the theory.
Learn Bonds is bullish on junk bonds. However, there is a recent trend that scares us: Financial advisors are increasingly buying junk-bond funds for their clients, instead of more traditional bond funds. And as we outline below, they are likely doing so for the wrong reasons.
This year is shaping up to be a near record year for junk-bond issuance. As of July, $160 billion worth of junk bonds have been issued. The all-time high in the United States is $264 billion — a record set in 2010. Companies are racing to take advantage of the very low interest rate environment, and the market’s increased appetite for high-risk debt.
What is problematic (or interesting depending on your perspective) is that individual investors, along with their financial advisors, are playing a major role in buying these bonds. BlackRock estimates that 10% of the daily trading volume in junk bonds is attributable to junk bond ETFs. In fact, the two most popular high-yield bond ETFs — SPDR Barclays Capital High Yield Bond ETF (NYSE:JNK) and iShares iBoxx $ High Yield Corp Bond ETF (NYSE:HYG) — have grown their assets by more than 35% this year.
Junk bond prices show a higher correlation with stock prices than with other investment grade bonds, such as treasuries. The main question with junk bonds is whether or not the issuer can survive long enough to pay the debt you hold?
As a result, any good news about the company’s fortunes will move the price of the bond higher. Conversely, bad news will have the opposite impact. Studies have shown that 60% of the change in junk bond prices is related to changes in equity prices. For most types of bonds, changes in interest rates are the dominant reason for price movements.
Investors don’t like low yields. Unfortunately, many investors leave their financial advisors when their portfolios are returning in the low single digits. As a result, many financial advisors are lightening up their client’s holdings of more conservative bond funds, and adding junk bond funds in their place to try increase yields.
The main point of holding bonds is to provide portfolio diversification. Bonds that behave like stocks when the market is rising, also perform like stocks when the market is diving. When the bond allocation of your portfolio is mainly in junk bonds, its no longer a diversified portfolio.
Does this mean that no one should buy junk bonds? No, it does not. However, the investment should be made only after considering all the factors (like an investor’s risk tolerance, how diversified the portfolio is and so on) — not based only on higher yields.
We are bullish because of one simple word: value. The default rate on junk bonds has been running low for the last two years — around 2%. All three major rating agencies expect the default rate for junk bonds to be under 3% this year. However, the market is pricing junk bonds as if the default rate will be be doubling in the next couple years. Provided that we don’t fall into another recession, junk bonds are a screaming buy compared to investment grade bonds.
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