Seeking Yield? Don't Look for it in Junk Bonds Right Now

Junk bonds comprise a key segment of fixed-income offerings. They have regained their popularity with many investors in recent years because they provide higher yields than guaranteed offerings. But despite the fact that this segment of the market has doubled in the last five years, current market conditions may be working against it, as interest rates are likely to rise and the prices of commodities have fallen. The high-yield bond fund category is down an average of -8.22% over the past year (to Feb. 18, 2016), which lags the SPDR S&P 500 ETF (SPY), which is currently down -6.68%.

If you are thinking about investing in debt that is ranked below investment grade, here are some things for you to ponder while you decide.

The recent oil boom has been a major contributor to what may become a junk bond crisis before it’s over. When the price of oil was high, many energy companies issued bonds that were rated below BBB+ because they were generating enough revenue to cover their payments with no problem. But now that prices are coming down, many of these firms are having trouble meeting their obligations, and several major companies such as Royal Dutch Shell and Chesapeake Energy are now in danger of having their debt downgraded by the ratings agencies. And energy companies comprise about 20-25% of the junk bond market-enough to trigger a major collapse if things get bad enough.

There have been more downgrades in junk bond ratings than upgrades during the past year, and this trend is likely to continue for the foreseeable future. Issues of new junk bonds are also likely to decrease, and the default rate for junk offerings is predicted to rise as high as 6%, which is nearly double what it was just a short time ago. And a collapse in the junk bond market may spread to other sectors of the market such as investment-grade debt or even the stock market, just as it did in the late nineties.

Junk bond prices will also be hit harder when rates start to rise than other types of debt because of their higher yields. Junk bonds were producing a composite yield of over 9% about a year ago, but the outlook for this sector at this point is rather grim. The problems in this sector are also echoing other problems in other sectors, such as the Chinese stock market, corporate grade bonds, emerging market currencies and foreign real estate.

A recent survey of senior loan officers at banks revealed that most of them are looking into tightening their underwriting criteria, which does not bode well for junk issuers who are in need of financing. Slowing global economic growth provides another bearish indicator for junk bonds. Strategists at the World Bank have been downgrading their expectations for global growth every quarter for the last two or three years. Corporate profits have also slowed down, with the latest round of earnings reports from S&P 500 companies showing a reduction in profits and revenue. And three junk bond funds have also experienced major distress. The Third Avenue Capital Management LLC junk bond mutual fund was recently liquidated, the hedge fund Lucidus Capital Partners (which was heavily invested in junk bonds) went belly up and the fund managers at Stone Lion Capital Partners decided to prohibit shareholder redemptions. Fortunately, these funds are relatively small and not terribly representative of the average junk bond fund, but the question is, will more junk bond fund failures follow these, or was this just flukish?

Although the short-term outlook for junk bonds is bleak, there may be a rainbow waiting for those who ride out the storm. Junk bonds typically do well after recessionary periods, as they did after 2008 when their yields climbed to almost 20%. It is possible that analysts will look back at this period and conclude that high yield bonds bottomed out at the same time as oil prices. But the time to recovery will depend heavily upon what the markets do from here.

Junk bonds get their nickname from their inability to achieve an investment-grade rating. But many of these bonds pay handsome yields to investors who are willing to endure a higher level of risk. However, the current market outlook for these instruments is solidly bearish, and falling energy prices have left many companies in this sector scrambling to make their principal and interest payments. Investors who are seeking higher yields may want to look to other sectors, such as preferred stock, as a safer alternative to offerings that are below investment grade. But the long-term prognosis for junk offerings is probably a bit more optimistic, and the S&P U.S. issued high yield bond index has only dropped by about 2.5% as of December 2015.