Junk yields hit 3-year low, and some investors are getting scared

Key Points
  • Investors are getting 6 percent yields on the riskiest bonds in the market.
  • Some investors are backing away, with junk allocations at lows not seen since the financial crisis.
  • The market is being supported by low interest rates and few defaults.
Drilling down on high yield

Investors are getting the lowest yields on the riskiest bonds in almost three years, another sign of the high level of complacency in financial markets.

The Bank of America Merrill Lynch U.S. High Yield index is showing that so-called junk bonds are delivering yields of just 6.02 percent, down 40 percent from the more than 10 percent rate in early 2016 and at a level last seen around June 2014.

A decline in yields indicates investor demand for products at the high end of the risk scale. Demand drives prices higher and thus sends bond yields lower under the dynamics of the fixed income market. The trend comes at a time when volatility has subsided across markets, with one measure of stock market fear, the CBOE Volatility Index, hovering around historical lows.

Junk bonds and stocks often move in tandem, particularly in strong markets, and it appears again that the relentless optimism among equity investors is spreading.

"If the stock market is performing well, which it has been, high-yield also will do quite well. The correlations are much higher," said Peter Schwab, portfolio manager at Pax High Yield Bond Fund. "A lot of these companies, while they have a lot of debt, they're performing well."

A look at the trajectory of junk bond yields over the past five years.

Source: FactSet

Indeed, in an era of low rates and low defaults, companies have been piling on debt.

Corporate debt currently stands at $8.52 trillion, up 57 percent from the dark days of the financial crisis in 2008, according to the Securities Industry and Financial Markets Association. Companies have been particularly aggressive in the high-yield space, with issuance year-to-date 56.6 percent ahead of the pace for the same period a year ago.

Defaults have been low, with the speculative-grade rate at 4.7 percent in the first quarter and expected to fall to 3 percent in a year, according to Moody's ratings service.

However, investors are raising the same questions about the junk bond market as with stocks: Have things gotten too calm, and is there a storm coming?

"Given the weaker economic data, stress from retail and autos, and tight valuations, we continue to think high yield is susceptible to a backup later this summer," Michael Contopoulos, high-yield credit strategist at Bank of America Merrill Lynch, said in a note to clients.

He's not alone in his views.

Allocations lowest since the crisis

An investor survey by the bank showed the underweight tilt — the level of exposure compared to the long-term average — at its lowest level since June 2008. Respondents cited geopolitical risk as their biggest fears, followed by U.S. fiscal policy, China, oil and rising rates.

The low yields have been accompanied by low returns for funds that track the high-yield market.

The largest junk-related exchange-traded fund, the $17.5 billion iShares iBoxx $ High Yield Corporate Bond, is up just 1.9 percent in price year to date, compared to the 's 7.2 percent.

Bond experts say that while there are no signs of an imminent collapse, opportunities are harder to come by these days.

Commuters walk through a Wall Street subway station near the New York Stock Exchange.
Michael Nagle | Bloomberg | Getty Images

Rather than look at yield in a vacuum, bond investors use government bond yields as a comparison tool to determine value. Spreads between high-yield and Treasurys now are around half the normal level, meaning that the payoff is lower compared to the risk.

"The core U.S. high-yield market is definitely on the more expensive side," said Gershon Distenfeld, director of credit at AllianceBernstein. "The market is a little ahead of itself. The market was to say the least cheap back in the beginning of January (2016). I definitely think it's on the expensive side (now)."

Distenfeld said he's focusing clients on high-income instruments.

Similarly, Marc Bushallow, managing director of fixed income at Manning & Napier, notes opportunities in asset-backed securities in prime loans and government guaranteed loans to reduce risk and is generally avoiding debt with unstable collateral, such as subprime auto loans.

In other words, his firm is higher on the credit ladder and avoiding some of the more dangerous parts of the market.

"It's a low-yield environment and we think it's about blocking and tackling day to day," Bushallow said. "It's about taking risks where clients are going to get paid for it."