Most of the time, junk bond funds don't present huge problems to investors. Most people repay their debts; so do most corporations. The high yields from a diversified portfolio of junk bonds can overcome the occasional default.
Every so often, however, corporate lenders undergo a kind of mania that's not entirely different from manias in stocks, baseball cards or tulips. And while crying, "Bubble!" has been a cottage industry for some pundits, you can argue that high yield is starting to look, well, bubbly.
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A bubble doesn't just mean that prices seem weirdly high. Anyone who remembers when the Dow Jones industrial average broke through 2,000 blinks when he sees the Dow nudging up against 17,000. But corporate earnings have grown enough since January 2007 to support higher prices — or at least to argue that it would take a great deal of woe to get back to 2,000.
In the case of high-yield bonds, prices are indeed at an all-time high. One way to measure a bond's price is its yield — and, in the upside-down world of bonds, the lower the yield, the higher the price. This week, Barclays Capital High-Yield Index yielded 4.83%, the lowest yield for junk bonds in history
Yields are low compared with other bonds, too, says John Lonski, team managing director, economics group, at Moody's Analytics. Junk bonds yield about 3.29 percentage points above comparable Treasury securities — not quite a record, but certainly close to their 2007 lows.
One of the hallmarks of a bubble is that new, even riskier investments start to appear. For example, in the 2007 bubble, investors bought packages of shaky mortgages to goose up their yields. Nowadays, investors are buying packages of shaky auto loans. The Office of the Comptroller of the Currency, alarmed, has cautioned banks about making too many of those loans.
And, of course, when the demand for anything is brisk, Wall Street is glad to feed the demand. "There were five deals priced yesterday, and they were all oversubscribed," says Ron Heller, CEO of Peritus Asset Management in Santa Barbara, Calif. Typically, that means investors paid too much. And a wave of new bond issuance has swept Europe, with 75% being rated below investment grade — in other words, junk.
At the same time, the number of rating downgrades for junk bonds is outpacing the number of upgrades. "You have to use more caution and credit selection than you did before," says Hozef Arif, portfolio manager at Pimco. "Avoiding losers is as important as picking winners."
When you're at record low yields, there's nothing to say that yields won't go lower. If the economy improves, so should the finances of the companies that issue junk bonds.
But at these levels, "the odds are against you," Lonski says. Junk could get hit in two ways. A rise in interest rates would hurt bond prices in general. And an increase in defaults — the result of a punk economy — could hurt junk, too.
In true junk routs, another problem emerges. When everyone heads for the exits, fund managers must sell bonds to pay departing shareholders. But in a panic, there are no buyers. Managers must sell their highest-quality bonds, often at steep price reductions, to meet redemptions. As a result, the overall quality of the bonds in the portfolio deteriorates, leaving investors with, well, junk.
The worst-case scenario is a meltdown like 2007-2008. In the 12 months ended November 2008, the average junk fund fell 30%, including reinvested interest. In contrast, the average intermediate-term government bond fund rose 2.33%.
The 2007-2009 financial crisis was a generational event, and probably unlikely to be repeated any time soon. A more likely result is that you'll have a period of low or mildly negative total returns — interest plus principal. "Your expectations should be that earning your interest is as good as it gets," says Wayne Schmidt, chief investment officer at Gradient Investments in Arden Hills, Minn.
You can mitigate your interest rate risk, to some extent, by investing in funds that buy short-term junk bonds. Typically, short-term bonds aren't hurt as badly as long-term bonds when interest rates rise. Schmidt recommends exchange-traded funds that buy short-term junk. One example: SPDR Barclays Short Term High Yield Bond ETF (ticker: SJNK).
If you've owned a junk fund for a long time, consider paring back and distributing the proceeds to other parts of your portfolio. For example, if you originally had 10% of your holdings in junk bonds and you now have 20% there, think about selling enough to get you back to 10%, particularly if you're in a tax-deferred retirement fund, such as an IRA.
But if you're thinking of investing in a junk bond fund, you should probably think again. You don't want to find yourself staring at a hole in your portfolio and wondering how on Earth it got there.
—By John Waggoner, USA Today