How popular are junk bonds these days? Very. High-yield is delivering much lower yields lately as investors snap the offerings up amid a large issuance of new junk. And that spells price appreciation.
The average yield on junk is approaching 4.0%, and is at the lowest point in the past quarter century, according to the ICE BofA High Yield Index.
In fact, BCA Research likes junk bonds better than supposedly less-risky investment grade corporate bonds. “We prefer high-yield over investment grade within the US corporate space, particularly the Ba credit tier,” the well-respected research firm wrote in a client note last week. The reference was to the highest speculative grade rating level from Moody’s Investors Service.
For investors, the major takeaway is that high-yield is less risky now.
As Seth Meyer, portfolio manager at Janus Henderson Investors, put the matter in a blog post favorable to junk, “the average credit quality of the high-yield corporate bond market has improved over the last decade.”
And how. One rule of thumb is that when the average junk yield falls beneath 5% annually, things are going swimmingly in the land of below investment grade. “The steady, collective hand of bond traders has gently guided risk expectations lower, especially since last November when the spread fell below 5 [percentage points] on a sustained basis,” pointed out Delta Investment Management, in a note.
Last March, as the pandemic walloped capital markets, junk shot up above 9%, from 5.3% at year-end 2019. The most dire showing this century was 21.8% in November 2008, amid the financial crisis, as investors unloaded their high-yield holdings, sending prices skidding. (Bond prices and yields, of course, move in opposite directions.)
The spread between Treasurys, touted as risk-free, and junk has been narrowing. It’s now 3.68 percentage points. Indeed, CCC-rated junk, the worst grade before default, is a mere 0.2 point lower than the all-junk average, BofA reported.
In the terrifying days of last spring, predictions were rife that default rates would skyrocket into the low- to mid-teens, as they did in reaction to the financial crisis. Standard & Poor’s last March predicted that junk , at 2020’s outset sporting a low default rate of 3.5%, would catapult to 12.5% at the end of the year.
Didn’t happen. In December, defaults were 6.6%. One big reason was that the Federal Reserve offered to backstop some junk, namely the so-called “fallen angels”—investment grade issues that are downgraded to high-yield. While not a lot of that fallen angel rescue buying actually occurred, the Fed’s offer was reassuring to the market.
Junk and stocks roughly track one another—while investment grade corporate bonds often may differ in performance from equities. The oft-cited reason for the junk-stock match is that, in an economic downturn, which slams stocks, junk bonds suffer out of investor concern that they will default. In other words, investors worry that companies may lack the cash flow to service their high-interest debt securities.
Not a problem now: Stocks of late are hitting new highs, as company earnings continue to improve.
What problems there are, Bank of America researchers pointed out, are limited to energy and coronavirus-exposed sectors, such transportation. So “elsewhere credit conditions are peak bullish,” the BofA report read.