Don’t Dismiss Carl Icahn’s Warning on Junk Bonds

Carl Icahn is worried about a crash in the junk bond market, and as much as the activist investor and former corporate raider can be self-serving, he’s right that high-yield debt is getting riskier all the time.

junk bonds carl icahn icahn enterprisesHey, it’s not like Carl Icahn is making some bold pronouncement. It’s not hard to find people warning of a huge bubble in bonds. After all, fixed income has been in a bull market for 30 years, and bond prices are riding high on ultra-low interest rates.

At the same time, ultra-low rates have investors reaching for yield, and that’s where junk bonds come in.

Low-risk Treasuries pay paltry interest. The benchmark 10-year notes yields only about 2.14%. Investment-grade corporate debt indices have yields of just 2.28% to 4.5%.

By comparison, an index for the lowest quality junk bonds has a yield of 10.5%. Less risky junk bonds can still offer yields of 5% to 6%. That looks pretty good considering the difficulty of generating much income in this market.

Those yields have made junk bonds very popular — perhaps too popular. Demand for high-yield debt has made junk bonds the top performer in the U.S. fixed income market so far this year. High-yield debt returned 3.8% for the year-to-date, according to the Bank of America Merrill Lynch Global Index System. That compares with 1.7% for investment-grade bonds and 1.3% for Treasuries.

And so the biggest junk bond exchange-traded funds are as popular as ever. Volumes for the iShares iBoxx $ High Yid Corp Bond (ETF)(NYSEARCA:HYG) and the SPDR Barclays Capital High Yield Bnd ETF (NYSEARCA:JNK) have picked up and even set some records.

Are Junk Bonds Frothier Than Stocks?

That outperformance is keeping Carl Icahn up at night. As he said on “Wall Street Week” this past Sunday, the stock market is dangerously high, but junk bonds look even worse. Carl Icahn said that when the high-yield market starts to come down, “there is going to be a great run to the exit.”

So, what would precipitate a decline in the junk bond market? Rising interest rates. Bond prices rise when rates fall, and with the Federal Reserve widely expected to raise rates at some point later this year, it would appear that junk bonds are primed for a fall.

True, another recession would also cause a lot of damage in the junk bond market. Companies with low credit quality have less financial wherewithal compared to, say, blue-chip companies. If business dries up, it’s more likely that such a company will default on its high-yield debt. But that doesn’t look like a risk at the present time and high-yield defaults remain low.

Additionally, volatility, especially on the short end of the yield curve, has been abnormally quiet through the period of ultra-low rates. As we get closer to a rate hike, we’re likely to see a pick up in volatility, which could be magnified in the riskier market for junk bonds.

Carl Icahn is concerned about a correction in the stock market or bond market, and there’s nothing wrong with that. Both are probably due for one. But that doesn’t necessarily have to turn into a full-blown rout.

Markets are much more likely to crumble on surprises, and with the Fed telegraphing its every move clearly, the junk bond market should be able to position itself for the inevitable hike in rates.

High-yield bond prices will fall, but they don’t have to collapse. Rates will still be terrible after a rate hike, and investors will still hunger for the kind of yield only junk bonds can provide.

That said, the remarkable run in junk bonds can’t go on forever, so investors would be wise to keep Icahn’s warning in mind for the future.

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

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