How to Thrive Amid the 2023 Junk Bond Slump

One truth about investing is that hard economic times aren’t kind to junk bonds. In early 2020, as the pandemic pushed the U.S. into a (brief) recession, junk’s average yield rocketed to 11.4% and prices plummeted, according to the ICE BofA High-Yield Index.

The almost universal expectation nowadays is that a recession awaits us sometime in 2023. Buy-and-hold investors likely will ride out the storm, but for those of a trading bent, there’s a two-step maneuver that has worked well in the past, says Martin Fridson, one of the foremost experts on high-yield.

It involves seeking safety in BB bonds, the highest-rated junk, and playing vulture investor with CCC credits, the lowest rated. “The vultures do well” with this strategy, says Fridson, previously affiliated with one-time bond powerhouse Salomon Brothers, then in top jobs at Morgan Stanley and Merrill Lynch. Today, he is a partner with Lehmann Livian Fridson Advisors.

In a recession, BBs lose just 8% in price, says Fridson, who dives deeply into historical statistics. That makes them a pretty decent place to hide out. The market already is this. Bank of America finds that BBs have gained 1.8% in total return (price plus interest) over the three months ending in early December, as compared to negative 1.9% for CCCs. That looks like a foreshadowing of things to come.

“Historical experience shows peak interest rates at the start of a recession,” Fridson explains. As time wears on, the rates descend and prices spring back. “BBs outperform, and some are rewarded with upgrades.”

Meantime, CCCs tend to get smashed, their prices tumbling with default rates of around 30%. Their prices often fall to as low as 40 cents on the dollar, he recounts. That spells a bargain for vulture investors. The trick is to use fundamental analysis to figure out which bonds are in the 70% that will not default. “Pivot to the CCC survivors,” he advises, and buy them at the cut-rate price.

Then when the storm abates and a recovering economy puts an end to the CCC default washout, the remaining paper sees its price restored, and investors can book a capital gain.

The ICE index shows that junk now yields around 8%, double what it was at the start of 2022. If things get worse, possible gold lies in the junkyard.