The continued slow trickle of decent economic news -- steady job growth, no fiscal-cliff dive -- is messing up the flight-to-quality trade. The yields on Treasuries and high-grade corporate bonds have been inching up, triggering price drops equivalent to 50% or more of the bonds’ annual yield.
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Two high-grade bellwether ETFs, The Vanguard Total Bond Market ETF (BND) and Bill Gross’ Pimco Total Return Bond ETF (BOND) have 30-day annualized yields of 1.6% and 2.3% respectively. Amid the encouraging economic news, both have given back more than half their annual yields in price declines. Meanwhile, junk bonds, which behave more like stocks than bonds, have rallied on the cloud clearing.
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If you’re inclined to think the economic news will continue to trend better rather than worse, junk looks like the more promising income pocket within the bond world. But it’s also increasingly pricey as well, as the average junk yield has slipped below 5%.
A year ago, a leading index of junk bonds yielded 5 percentage points more than Treasuries. Today that spread is down to 3.5%. On both a nominal and relative basis, junk is anything but cheap.
And if you do subscribe to the glass-half-full outlook of a stabilizing economy, investing in a stock with a stable but high dividend could be more advantageous than getting the same income from a junk bond. For example, right now Conoco-Phillips (COP) and Royal Dutch Shell (RDS-B) have junk-like dividend yields.
Both have been muddling along amid sluggish energy demand; earnings have dipped a bit the past year. But with sub-10 PE ratios, this is when patient investors can get positioned for the next cyclical upswing, which would send oil prices upward, while getting paid a nice dividend yield.
And what if instead we hit a rough spot or recession? Well, junk is just about the last place you want to be in that scenario. The prospects of fiscally-shakier companies -- after all, there’s a reason they have a junk rating -- get hammered at the first whiff of a slowdown. During the worst of the 2008-2009 bear, the SPDR junk ETF’s price cratered -39%. The total return loss was a slightly less painful -35%, thanks to double-digit junk yields at the time. But that’s still an equity-like performance, and today’s 5% junk yield provides far less cushion in a downdraft.
The same 5% yield also mutes future total return opportunity. Bond prices rise when yields fall; junk today has ever less room for big yield declines that can generate strong total returns.
Carla Fried, a senior contributing editor at ycharts.com, has covered investing for more than 25 years. Her work appears in The New York Times, Bloomberg.com and Money Magazine. She can be reached at firstname.lastname@example.org.
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