CNBC Explains

What the scare in the junk bond market means for regular investors

Tim Mullaney, special to

What does the sudden scare in the junk bond market mean for regular investors?

Not much.

The big selloff Friday and Monday was driven by institutions, sparked by the planned closing of junk bond–focused mutual fund Third Avenue Capital Management LLC, the demise of junk-focused hedge fund Lucidus Capital Partners and Stone Lion Capital Partners' decision to bar redemptions by fund holders. That set off a wave of trading in junk-focused exchange-traded funds, including the largest: BlackRock's iBoxx High-Yield Credit Fund.

But a combination of economic fundamentals, along with the small size and highly unusual trading tactics employed by the closed or crippled funds, point to this as being a storm that will blow over relatively quickly.

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"It appears that angst surrounding the probable Federal Reserve rate hike, along with slumping oil prices and large redemptions in junk-bond funds, are hurting high-yield credit markets, driving prices lower and yields higher," economists at Moody's Analytics wrote Monday. "The bad news is that it will likely get worse before improving. The good news is that the economic costs seem small for now."

Two reasons for that: The funds in trouble are small, and they are not very representative of even junk bonds, let alone the broader economy or market.

The funds that have decided to close, or halted redemptions, ranged in size from $400 million in assets under management to about $1.3 billion — by contrast, fund giant BlackRock manages about $4.5 trillion, including $15 billion in its closely watched iBoxx High-Yield Credit exchange-traded fund. That fund has lost about 6 percent of its value in the last month. BlackRock confirms that it has had $560 million of redemption requests for this fund last week, but said swings that big have happened four other times this year alone.

Overall, the junk bond market isn't having a great year, but it's not anything like a crisis. The Standard & Poor's U.S.-Issued High Yield Bond Index is down only 1.73 percent in the fourth quarter, as expectations of a Federal Reserve rate hike rose. It's down 2.4 percent for the last 12 months.

Read MoreWhy junk bonds won't spark another crisis

Beyond that, the problem among junk bond issuers, as opposed to traders, is concentrated in the energy sector, where plunging oil prices have cut into (or eliminated) the profitability of drilling and pipeline projects that the junk bonds financed. About a quarter of this year's junk defaults stem from the energy sector, Moody's says.

Overall, default rates among junk bond issuers are projected to move about 3 percent next year.
Moody's Investors Service

Overall, default rates among junk-bond issuers are projected to move about 3 percent next year, according to Moody's Investors Service, up from 2.7 percent in the first 10 months of this year. Barring a surprise, junk defaults will still be well below the long-term average of 4.6 percent. And since most issuers have taken advantage of cheap money to lock in low rates, few junk bonds mature next year, Moody's says.

In an improving economy, aside from the export sector, there isn't much reason for a wider range of companies to run into financial trouble. For example, the BlackRock fund's biggest holding is bonds of hospital chain HCA, which has $28.4 billion of debt, mostly from a leveraged buyout in 2006. HCA has been servicing that debt since, and its earnings before interest, taxes and noncash charges over the first nine months of this year is about three times the interest payments. Unless people have a lesser incidence of getting sick, HCA's bondholders will be repaid on time.

The BlackRock fund's other top holdings include telecom companies like T-Mobile and Sprint and technology giant Cisco Systems, which also don't have obvious macroeconomic challenges. None of its 10 top holdings is debt issued by an energy company.

Third Avenue's failure is a sign of how hard one has to try to run a high-yield fund into the ground. More than half the fund's assets were in bonds rated CCC or lower, the levels where rating agencies think near-term default is highly possible or even likely, or are not rated at all. With junk of all grades representing only about a quarter of the corporate bond market, defaults on investment-grade debt are very rare — none have happened in the last year.

Read MoreJunk bonds in your portfolio: What to do

There's little sign of any contagion spreading into the exchange-traded funds investors use to bet on diversified high-yield portfolios. Indeed, investors have actually added a net $3.85 billion to high-yield funds this year, raising the category to more than $44 billion, according to FactSet. The biggest withdrawals have come from a leveraged-loan fund, Invesco's PowerShares Senior Loan Fund, which had lost $1.1 billion, to fall to $4.4 billion in assets, FactSet said.

Leveraged loans, because they are illiquid, are a riskier asset class than most high-yield bonds.

High-yield... it's not what you own, it's about what you don't own: AB CEO
High-yield... it's not what you own, it's about what you don't own: AB CEO

Still, the market is worried that the Federal Reserve's likely rate hikes will complicate life for junk bond investors over the next year.

When the Fed raises rates, it increases the competition for capital that junk bonds and junk funds face. Junk has been about the only game in town for yield investors, paying mid-to-high single-digit rates even as bank deposit rates lurked near zero.

That's about to change, but it won't change all that much. Most market-watchers don't expect the Fed to raise the Fed funds rate more than 1 percentage point over the next year. Even then, it's not clear whether it would much affect the price markets pay for Treasury bonds, which are a beacon of stability in shaky markets. Yields for 10-year Treasuries have made small moves this year but are almost exactly where they were at the end of 2014, despite clear signs all year that the Fed will raise rates relatively soon. They won't be surging to anywhere near where junk is now.

So why are prices of some junk bond funds and ETFs dropping sharply?

In a word, liquidity.

ETFs, unlike mutual fund shares, can be bought and sold directly. That means that if an investor wants to sell, a buyer has to be found. If investors want to redeem mutual funds, those calls are met by selling the fund's underlying assets — the junk bonds in this case — in the much bigger market for the bonds themselves.

When a small market like a rarely traded individual exchange-traded fund gets hit with sell orders, they can move prices rapidly, though some reports indicate that the ETF structure has done well to contain price moves this week.

What should a regular investor do?

In a word, diversify.

Junk bonds should only be a small part of most people's portfolios, anyway. Unless an investor is close to retirement age, financial planners normally recommend putting the largest share of assets into common stocks — not least because the S&P 500-stock index's yield, at 2 percent, is nearly as high as the payout on Treasury bonds.

None of the recent news for junk is exactly good — but nothing that has happened points to a reversal in the long-term performance of an entire asset class. Certainly, spreads between junk yields and safer debt, like Treasuries, are narrowing and will narrow further as rates rise. So you won't be getting paid as much to take the risk that the trading price of your high-yield bonds will fall, or that the specific bonds you own may default.

But history says keeping high yield as part of a bond portfolio increases overall returns without boosting risk, giant institutional investor TIAA-CREF said in a 2014 report. A handful of messes at small funds don't change that.

— By Tim Mullaney, special to