Global Policy Forum

Investors Take a Shine to 'Junk' Bonds

According to The Wall Street Journal Europe, investors are "once again piling into 'junk' bonds," bonds that are rated below investment grade and thus deemed risky by credit rating agencies. The selling point of such bonds is, of course, that they have relatively high yields, especially compared to "safe" but low yielding US Treasury bonds. The article fails to mention, however, that these otherwise highly volatile bonds are now seen to be less risky by insiders because of the European Central Bank's (ECB) provision of cheap cash that allows many firms to improve their financial situations. Investors are thus taking advantage of public interventions meant to stave of another financial crisis and doing so through the types of bonds that got us there in the first place. 

By Matt Wirz

February 27, 2012

Investors of all stripes are once again piling into "junk" bonds.

The buyers are coming from both sides of the investing fence—from bond investors eschewing the low yields of U.S. Treasury debt to stock investors seeking protection from swings in the market.

Retail investors have plowed $11.8 billion into junk-bond mutual funds this year, compared with $4.8 billion for stock funds and $9.9 billion for investment-grade bond funds, according to research firm Lipper. Mutual-fund managers say they are also increasingly buying up junk bonds, or bonds of companies with below-investment-grade credit ratings.

The buzz is building, even though the recent returns from junk bonds have been relatively meager.

Junk, or high-yield, bonds have returned 4.74% in 2012, trailing the 8.6% gain of the Standard & Poor's 500-stock index. Last year, investors achieved a 4.98% return on junk, better than the S&P 500's 2.1% but below the 8.1% return from investment-grade corporate debt.

The Dow Jones Industrial Average, and now the S&P 500, have both exceeded their 2011 highs. Yet the yield of the Barclays Capital U.S. Corporate High Yield bond index, which falls as prices rise, is still above the low hit in April 2011. The average bond in the Barclays index yielded 7.16% on Feb. 23, above the 6.75% low hit last year.

And the premium, or spread, high-yield investors get paid over U.S. Treasurys is 6.3 percentage points, still well above the record-low of 2.43 percentage points reached at the peak of the credit boom in mid-2007.

All that means junk debt has room to rise, fans say.

"High yield isn't near its lowest spread and is still above its long-term average," said Jim Swanson, chief investment strategist at MFS Investment Management. "All that has to happen for us to make money is for spreads to get tighter."

A strength of junk bonds right now is that companies are in much better shape, some investors say. They have used the recovery of the past three years to refinance their debt at lower rates rather than taking on new debt. That should help them better weather any economic storm and reduce default rates, the biggest worry for bond investors.

That has made the bonds more palatable to traditional bond investors who are on the hunt for yield. Ten-year Treasurys, for example, yielded less than 2% Friday.

"At some point it comes down to simple math," said Edward Perks, who manages funds that mix stocks and bonds for Franklin Templeton Investments. "When you have a 2% yield on the 10-year, generating even high-single-digit returns is difficult." At the start of the year, the $61 billion Franklin Income Fund was split 45% in stocks and 55% in bonds, with the bulk of the debt investment in high-yield.

With interest rates near record lows and unlikely to fall further, neither U.S. Treasury bonds nor investment-grade bonds are expected to deliver meaningful returns this year, fund managers say.

And while stocks stand to gain should the U.S. economic recovery gather momentum, they are volatile, making them particularly susceptible to negative events such as renewed turmoil in Europe or disruption from the U.S. election later in 2012. Average annual volatility of the S&P 500 has been almost double that of high-yield bonds, according to J.P. Morgan.

To be sure, because high-yield bonds occupy a middle space between stocks and low-risk bonds, investors buying them as an alternative make some sacrifices.

By switching from stocks, investors will forgo higher gains should worries about Europe fade and optimism about the global economy grow.

And junk-rated companies are among the most vulnerable to any sudden downturn in the economy, making them a much riskier alternative to Treasurys or investment-grade corporate bonds.

A year ago, many investors were caught wrong-footed when they moved out of investment-grade debt, only to watch Treasurys soar in value and junk bonds tumble as worries swirled about the global economy.

Gibson Smith, co-manager of the Janus Growth & Income Fund, is among those putting his faith in stocks instead. The fund has 63% of its assets in equities and 7% in high-yield.

Mr. Smith points out that stock-market volatility has declined as measured by the Chicago Board Options Exchange Market Volatility Index, or VIX. "Volatility is declining, and that's great for risk assets," he says.

Western Asset Management, though, is recommending high-yield as "an equity alternative" this year, citing the superior returns of the bonds relative to stocks since 2007. Steady interest payments helped high-yield deliver average annual returns of 7.16% in that time, compared with a negative 2.1% return for the S&P 500, according to research by Western.

Recent flows into mutual funds indicate some other investors agree. Over the past 10 years, net flows into equity mutual funds have outpaced those into junk funds almost three-to-one. But since 2009, high-yield funds took in $74 billion, while domestic stock funds lost $95 billion.

Bond investors argue that, with the economy growing steadily, Treasury rates are likely to move up in the medium term. As rates rise, bond prices typically fall. That adds more to the risk in Treasury bonds than in junk debt, said MFS's Mr. Swanson.

The $724 million income fund that Mr. Swanson manages is 27%-invested in high yield, above the typical 25%, and 17%-invested in investment-grade and Treasury bonds, compared with 20% normally.

"I want something that feeds me at night," he said.


FAIR USE NOTICE: This page contains copyrighted material the use of which has not been specifically authorized by the copyright owner. Global Policy Forum distributes this material without profit to those who have expressed a prior interest in receiving the included information for research and educational purposes. We believe this constitutes a fair use of any such copyrighted material as provided for in 17 U.S.C § 107. If you wish to use copyrighted material from this site for purposes of your own that go beyond fair use, you must obtain permission from the copyright owner.