While junk bonds have often been considered the pariah of the bond market in the past, a robust fundamentals setting is helping to bolster what is frequently seen as one of the riskiest products in the financial markets.
Bond yields, which run inversely with bond prices, for the lowest-grade bonds are near historic lows after a rollercoaster of a year that was rocked by the coronavirus pandemic. Nevertheless, many companies managed to post surprisingly healthy balance sheets.
According to the ICE Bank of America High-Yield index, the junk bond sector collectively is yielding 3.97%. That’s after hitting a record low of 3.89% on Monday.
Historically, junk bonds have average yields between 4% to 6% above those for comparable U.S. Treasuries, which are viewed as significantly safer. U.S. bonds are typically considered the benchmark for investment-grade bonds because the nation has never defaulted on a debt.
In March 2020, at the height of pandemic volatility, the yield was at 9.2%. This was a historic moment, where the collective yield for junk was actually below the rate of inflation as measured by the now-hot consumer price index, which climbed 5.4% in June year over year.
In addition, spreads between high-yield bonds and Treasuries of similar duration have dropped to 3.05%, slightly above the lowest levels since June 2007.
“Corporations weathered the storm last year and have positioned themselves really well,” said Collin Martin, fixed income strategist at Charles Schwab. “Couple that with yield-starved investors going into anything and everything that offer better than a 0% yield, and it’s really the perfect storm to see spreads drop to those pre-financial crisis levels.”
While inflation has become the topic of heated debate recently, with key measures of inflation like the CPI rallying, according to some analysts, there is also a chance that inflation will settle down as the pandemic’s anomalies become less fresh, leaving junk bond yields again above the rate of price increases.
Gennadiy Goldberg, U.S. rates strategist at TD Securities, said the inversion indicates investors are chasing returns far and wide in a low-rate environment, even in riskier places.
“This is a function of too much cash in the system and too few attractive assets for investors to put their cash into,” he said.
Thanks to historically low interest rates, companies have created massive cash positions over the past several years, with liquid assets at nonfinancial companies reaching $6.4 trillion through the first quarter of 2021, according to the Federal Reserve. That number amounts to an increase of almost 50% since just 2018.
High-yield debt issuance has totaled $298.7 billion in 2021, up 51.1% from the same point in 2020, when markets witnessed an incredible $421.4 billion in junk issuance, according to SIFMA data. At the same time, investment-grade issuance has tumbled 32.7% this year.
While junk bond ETFs have yet to deliver massive returns, the $9.3 billion SPDR Bloomberg Barclays High Yield Bond ETF (JNK) does offer a yield of 4.21%.
“It’s a tough world as an investor, because valuations are awful but fundamentals are pretty good. Usually, fundamentals win out,” said Tom Graff, head of fixed income at Brown Advisory. “We’re pretty cautious on high yield. We own some. That risk-reward is so skewed right now, but you need to be realistic. It’s probably not going to go the other way anytime real soon.”
Graff said investors can minimize risk by looking to single- or double-B companies rather than the riskier C-rated funds.
“Because of all the downgrades that we saw last year, the credit quality in the market is higher than it’s ever been historically,” said Bill Ahmuty, head of the SPDR Fixed Income Group at State Street Global Advisors. “That’s helping to drive overall yields lower and spreads a little lower.”
Analysts are predicting that there will be an increase in the credit quality of some beaten-down companies, known as fallen angels, which reached a record in 2020.
“High-yield indices are higher in credit quality. You have lower projected default rates and you have this component where you’re going to see rising stars over the next couple of years,” he said. “There’s a good fundamental backdrop there.”
While the Federal Reserve has said it will keep rates low until its employment objectives are met, the threat of a tighter central bank always looms over the bond market, however.
“What kills a credit rally is the Fed tightening. More hawkish than expected rhetoric from the Fed can kill a credit rally as well,” Martin, the Schwab strategist, said. “We’ve seen very high inflation spikes and indications from the Fed for more hikes than anticipated. But the markets are just shrugging it off.”
It is also critical to remember that junk bonds are a high-risk investment, and that there is a chance that the issuer will file for bankruptcy. As a result, the market is typically dominated by institutional investors with specialized knowledge.
However, for ETF investors looking to get in on the action, one ETF to consider is the Invesco Fundamental High Yield® Corporate Bond ETF (PHB). The $844.4 million PHB follows the RAFI Bonds US High Yield 1-10 Index.
“Traditional bond indices, which are weighted by the amount of debt outstanding, may not always be optimal for passive solutions. In traditional indices, the most indebted issuers receive the largest index weights. Weighting according to the debt appetite of bond issuers can leave investors overexposed to firms with poor credit quality, without compensation for the added risk they take on,” according to Research Affiliates, PHB’s index provider.
While PHB isn’t the highest-yielding junk bond ETF out there, it is credibly levered to a recovering U.S. economy because consumer discretionary and energy debt accounts for about a third of the fund’s weight. Ninety-six percent of the fund’s holdings have maturities of one to five or five to 10 years.
Another option for investors is the VanEck Vectors Emerging Markets High Yield Bond ETF (HYEM).
“The global exposure of many of the issuers allows the category to benefit from the spike in expected global growth rates this year,” says VanEck Head of Fixed Income ETF Portfolio Management Fran Rodilosso. “At the same time, emerging markets high yield corporates are one of the few areas where investors can still find yields that are still well above 5%.”
For more market trends, visit ETF Trends.