Since interest rates plummeted, investors have been forced to get yield from alternative sources, including junk bonds.
Back in 2007, an investor could get 4% from a certificate of deposit or even a high-interest savings account. The yield on the 10-year treasury note was 4.5%. And if more income was required, the stock market was awash in securities that yielded 6%, 8% … even 10%.
These days, the search for yield is much tougher. Stocks that used to pay 8% now may yield half of that. CDs and high-interest savings accounts barely keep up with inflation. And while bond yields have been marching steadily higher since Donald Trump was elected president, investors looking for yields surpassing 3% have to buy 30-year treasury bonds.
Junk bonds have become a popular income option in today’s market. The SPDR Barclays Capital High Yield Bond ETF (NYSEARCA:JNK) yields 6%, while the iShares iBoxx $ High Yield Corp Bond ETF (NYSEARCA:HYG) throws off a still-generous 5.2%. Those are attractive income sources.
After all, junk bonds can be incredibly risky, as there’s good reason why junk debt yields more than investment-grade debt. But on the whole, junk debt actually has a low default rate. Thus, the yields on basket investments like JNK and HYG are safe — if investors can stomach the price fluctuations.
Even through the great recession of 2008-09, the vast majority of junk bonds continued to pay their obligations. Both HYG and JNK paid uninterrupted distributions to investors, with only a minimal impact. Thus, high-yield bonds should continue to provide investors a favorable income stream for years to come.
But I wouldn’t buy junk bonds right now.
Bonds have done something interesting since the November elections. Long-term Treasury bonds have fallen, sending yields higher. Junk debt has done the opposite. Both JNK and HYG are up 2%-3% (excluding distributions) since the first Tuesday in November, while long-term treasury bonds have fallen close to 10%.
There are a couple of explanations as to why this is happening.
One is Trump’s tax plan. While the details are far from being etched in stone. But if corporate taxes go down to 15%, it’ll suddenly make interest payments much more affordable, especially for weaker companies. In addition, Trump is viewed as pro-energy, and much of the energy sector’s debt is firmly in junk territory.
Ultimately, though, one factor should drive junk bonds.
It should be based on the premium an investor can get buying high-yield debt versus Treasury notes. An astute investor will buy when the spread is wider and sell when the spread narrows.
That spread is the lowest it has been since the middle of 2014, currently sitting under 4%. The St. Louis branch of the Federal Reserve has all the details.
We only need to look back to mid-2014 to see the potential downfall in buying junk bonds when the credit spread is this low. JNK traded at just under $42 per share in June of that year. In mid-2015, shares had fallen to $38 each before eventually falling to $32 each in February, 2016. That’s a decline of 24% from peak to trough. HYG saw similar losses.
The opposite thing happened in February 2016. The junk debt premium was flirting with 9%, which was the highest level in the preceding five years. That was the buy signal.
The Bottom Line on Junk Bonds
Historically, the trend has been pretty simple. When the junk bond premium falls to 4%, it has not been a good time to buy junk debt ETFs. It wasn’t in 2014, and it sure wasn’t in between 2005 and 2008, when the spread was under 3%.
Today is not the time to buy.
Investors should wait until the junk bond spread goes much higher, ideally to the 6% to 7% range, or perhaps even higher. If history repeats itself — which it often does when investing — an investor who gets into JNK and HYG at that range is likely to reap attractive capital gains along with a great income stream.