Don’t Listen to Junk Bonds’ 6% Siren Song! (JNK, HYG)

At first glance, last Friday’s action from junk bonds and related exchange-traded funds like the SPDR Barclays Capital High Yield Bond ETF (JNK) and the iShares iBoxx $ High Yield Corp. Bond ETF (HYG) looks capitulatory … as if a buy-worthy bottom had been made.

And, were the circumstances different, Friday’s drubbing following a prolonged pullback probably would serve as a buying opportunity.

In our current scenario, though, with a rate-hike looming (maybe more than one) at the same time a wide swath of energy companies are nearing default on their debt, now isn’t the time to be bargain-hunting in the junk bonds bin.

It truly could get even worse before it gets better.

Two (Big) Reasons to Steer Clear Of JNK and HYG

It’s not too difficult to look at Friday’s trading of JNK and HYG and come to a bullish conclusion. Aside from the bearish gaps left behind at the open, the flood of volume that poured out for each ETF suggests the last of any would-be sellers were flushed out that day, and the push up and off the lows Friday even implies the bulls were starting to trickle back in.

Despite Monday’s weakness from junk bonds, Friday’s bars scream “capitulation.”

Junk Bonds, iShares iBoxx $ High Yield Corp. Bond ETF (HYG)

This has been a downright goofy market, however, including for bonds, and just when it feels like things are about to normalize/stabilize, traders are thrown a curveball.

Translation: As tempting as it may be, it’s still too soon to dive into junk bonds for the purpose of bottom-fishing.

There are a handful of reason to steer clear of high-yield debt, though there are two overarching, inescapable ones.

The first one is the simple fact that the Federal Reserve has been longing to push interest rates higher for almost a full year now. It managed to find a way not to do so through the year so far, but come Wednesday, that’s widely expected to change — pros and amateurs alike are expecting the fed funds rate (the interest rate charges for overnight loans to banks) to move from 0.25% to 0.5%, thus shifting all bond yields higher. Interest rates on existing bonds are adjusted by lowering bond values, including junk bonds. Ergo, if we see a rate hike on Wednesday, look for pressure on the entire bond market.

And if it doesn’t happen this week, it’s in the cards soon, and most believe it’s in the cards more than once for the foreseeable future. The average current forecast suggests the fed funds rate will be at or near 1% by the end of the coming year.

And yes, there’s plenty of evidence to suggest a rising fed funds rate takes a big toll on junk bonds, even if only because higher-quality debt pulls some income-seekers away from riskier assets.

The other reason things could get worse before they get better for instruments like HYG and JNK: With no end to the oil rout in sight, already-stressed (and cash strapped) energy companies are headed for default. Last week, Fitch Ratings sounded off on the premise with some specifics, noting that 11% of the oil sector’s high-yield debt will likely move to a defaulted status next year … the highest since 1999, shortly after oil made precipitous plunge like the one it has doled out since the middle of last year.

While the energy sector only makes up an equitable portion of the junk bond market, don’t think for a minute it can’t lead the whole segment noticeably lower. More than 100 corporations have defaulted on their debt this year — the worst since 2009 — and nearly a third of those defaults have been energy or energy-related companies.

Point being, if oil prices don’t get much better real soon, the last of the sector’s hedges will expire, accelerating the cash crunch and spurring even more defaults on its high-yield debt.

That is enough to infect the rest of the junk bond market.

Bottom Line for Junk Bonds

The yields are admittedly tempting, but in the same sense that “cheap” doesn’t always mean “undervalued” for stocks, the term “high yield” doesn’t change the reality that many “junk bonds” are deemed such for a good reason.

Sure, they worked well for a while, for cyclical reasons, but that whole cycle is winding down. Indeed, multiple cycles are jointly starting to work against junk bonds. That’s not going to cause just a bit of turbulence. It’s going to cause a full-blown storm.

Batten down the hatches and buckle your seat belts.

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

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