How Much Higher Can Junk Bonds Go?

Nothing is a bubble until it bursts. But the fixed-income market is starved for yield and gorging on junk bonds, so it’s understandable if some investors are getting hinky.

Chalk it up to the risk-on trade, confidence that slow economic growth won’t slip into full-on recession (which would cause companies to default on their debts) and help from European buyers who are contending with even lower yields on safe government debt than their U.S. counterparts (bonds that also don’t pay squat).

The yield on the benchmark Barclays U.S. Corporate High-Yield index dropped below 6.5% this week — the first time that’s ever happened in the history of the index, which stretches back to 1983. Remember that bond prices and yields move in opposite directions, and that’ll help you understand how the index could return 12.2% for the year-to-date.

Between yield and price-appreciation, junk bonds are putting up essentially equity-like returns. The S&P 500, by way of comparison, has generated a total return (price gains plus dividends) of 16% for the year-to-date.

Popular junk-bond ETFs haven’t put up the same kind of returns, but they’ve still performed handsomely as far as fixed income goes.

Between price-appreciation and yield, the iShares iBoxx $ High-Yield Corporate Bond ETF (NYSE:HYG) returned 9.2% for the year-do-date as of Aug. 31. The SPDR Barclays Capital High-Yield Bond ETF (NYSE:JNK) returned 9.4% as of the end of August.

Nothing else in the U.S. debt market comes close to those kinds of returns. Only the Barclays U.S. Long Credit A index is even within striking distance. That index tracks a combination of investment-grade corporate and sovereign debt, among other issues, with maturities of at least 10 years.

Yes, it’s up an impressive 8.4% for the year-to-date, but that still lags the high-yield index by more than 4 percentage points.

And the crazy thing is, junk bonds probably still have room to run.

With the Federal Reserve keeping the yield curve as flat and low as possible, there’s simply no place else to turn for yield.

Meanwhile, if you’re an institutional investor holding euros, safety pays even less. Sure, the yield on the benchmark 10-year Treasury note throws off a pitiful 1.75%. But that’s a far sight better than comparable German bunds, which are spitting out an even more paltry 1.55%.

That has junk-bond mutual funds and ETFs seeing their highest levels of inflows since the Fed launched its first round of quantitative easing three years ago. Indeed, they’re on pace to break the record of $32 billion in full-year inflows set in 2009, according to data from fund-tracker Lipper.

In another boost for junk-bond investors, some strategists are telling clients to reduce interest rate risk, which is found in core bond mutual funds and Treasurys, in favor of credit risk, which is found in high-grade and high-yield corporate debt.

“Volatility in August … illustrates the potential risks in fixed income,” writes Jeffrey Rosenberg, BlackRock’s (NYSE:BLK) chief investment strategist for fixed income. “However, flat August returns for core fixed income … underscores the poor risk-reward we see in these sectors.”

The smartest play, then, is to favor corporate debt, both high-grade and junk.

As long as the market keeps favoring that mix, junk bonds should keep burbling along. Because when it comes to fixed income these days, safety just doesn’t pay.

As of this writing, Dan Burrows did not hold positions in any of the aforementioned securities.

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