Junk Bonds Living Up to Risky Reputation as Defaults Climb

Junk bond funds are up more than +20% off their March lows, and many of them still sport yields in excess of 10%. Though a double-digit yield is always tempting, now may not be the time to purchase high-yield bonds.

Junk or “speculative-grade” bonds are on the riskiest end of the debt spectrum. They’re issued by companies with more vulnerable financial foundations and lower credit ratings. That, unto itself, shouldn’t discourage investment in this often-rewarding asset class. In recognition of the risk inherent in junk bonds, they do pay rich yield premiums — well above the yield of the ultra-safe 10-Year U.S. Treasury. And many times an investor will find opportunities where the reward outweighs the risk.

But that’s not the case now. More companies are failing to pay back their loans. On top of that, junk bond yields are falling.

Greater Risk
Standard & Poor’s recently reported that the default rate on speculative-grade bonds climbed to 9.2% in June — up from 8.1% in May. A year ago, in June 2008, the default rate was a mere 2.0%, well below the long-term average of 4.9%.

Last month, 18 companies defaulted on their debt, bringing the total number of defaulting companies to 119 since the beginning of the year. Companies in the hard-hit automotive sector were well represented in June’s statistics, including General Motors and auto part supplier Lear. Since January 2008, some 50 auto parts suppliers have entered bankruptcy.

Apparel chain Eddie Bauer and developer Fontainebleau Las Vegas Holdings also defaulted on their debt last month, reflecting the still-fragile retail and resort sectors. S&P says the default rate will rise and could reach 14.3% by May 2010, and perhaps hit 18.5% if the economic recovery stalls.

Lower Reward
Last year, investors dumped risky assets, especially speculative-grade bonds, as the depth of the economic recession became known. By December 2008, the premium for junk bonds had been pushed to a record high, yielding 21.8% above Treasuries. But as economic indicators started to hint that the worst might be behind us, investors began to lock in above-average yielding junk bonds. Starting on March 18th, the junk-bond market saw 14 straight weeks of investment inflows.

The renewed investor interest in junk bonds has taken a toll on the yield premium. Last week the yield spread between junk bonds and treasuries had shrunk to 10.6%. And while a 10%-plus spread sounds impressive, it doesn’t mean anything if the issuer defaults.

Another Opportunity Pending?
Clearly the risk-reward sweet spot for junk bonds has passed — but a new junk bond opportunity may be on the horizon.

The supply of junk bonds has been increasing. In fact the supply of new speculative-grade bond issues has increased +38% over last year’s supply. As the junk bond yield premium has fallen, this has translated to lower borrowing costs for businesses. This, in turn, has resulted in more companies issuing debt. But the increasing supply could push junk bond prices down — and yields up — if there isn’t adequate demand for the new junk bond influx.

Also, the market rally that started in March has stalled and overall market sentiment remains fragile. If investors start to pull back out of risky assets while the junk bond supply increases, we may start to see some 15%-plus yield premiums again. At that point, investors may find some positive risk-reward opportunities in junk bonds. Should junk bond yields increase, investors can easily tap into this market by investing in a diversified exchange-traded fund (ETF) that holds junk bonds. ETFs are simple to trade, low-cost, and very liquid, making them easy to move in and out of. Three funds worth keeping an eye on include SPDR Barclays Capital High Yield Bond ETF (NYSE: JNK), iShares iBoxx $ High Yield Corporate Bond Fund (NYSE: HYG), and PowerShares High Yield Corporate Bond Portfolio (NYSE: PHB). All three funds currently yield over 9.0% and have an expense ratio of 0.5% or lower.