Low Junk Bond Yields Not Done Falling

With U.S. junk bond yields sitting at 6.33 percent and potentially headed toward a record low of 6.31 percent, it begs the question, Have junk bond yields found a bottom?

Far from it. The negative macroeconomic environment, combined with the Federal Reserve’s actions, may indicate that yields on junk bonds have nowhere to go but down.

Historically, junk bonds outperform in prosperous economic times when businesses are doing well, cash is abundant and even low-rated debt is paid off. This favorable combination usually drives yields lower, boosting junk bond prices, to the delight of junk bond investors (whether in ETFs, mutual funds or otherwise).

The opposite is also true:When the economic environment takes a turn for the negative, yields increase and prices drop as investors become increasingly concerned about the likelihood they will be repaid.

However, with the help of Federal Reserve Chairman Ben Bernanke, the latter part of this historical relationship no longer holds true. Today we are seeing near-historical lows for junk bonds amid an overwhelmingly negative macroeconomic environment.

What’s going on?

When the global macro environment turns negative, investors often respond by decreasing equity exposure and increasing fixed-income exposure, especially to U.S. Treasurys, where investors can usually secure moderate yield.

Today those yields don’t exist. The global rush to safety, combined with Bernanke’s pledge to keep long-term rates low, has brought yields so low that real long-term yields (yields minus the inflation rate) are now so low that they’re actually negative.

Nobody likes paying something for nothing. Some of the cash that would normally flow to Treasurys as the macro environment deteriorates will now find other outlets that offer real yield.

The junk bond market has certainly been a benefactor, as we have observed massive inflows to junk bond ETFs over the past year since Bernanke pledged to keep rates low. The inflows have helped drive yields lower, and the trend appears poised to persist.

The quest for yield is highlighted by the iShares iBoxx $ High Yield Corporate Bond fund (HYG), the most popular junk bond ETF, which has seen $7 billion inflows since “Operation Twist” was announced by the Federal Reserve on Sept. 21, 2011.

If economic conditions do improve, you might see the rush-to-safety buying abate, but it is likely that yields on junk bonds would decline further as debtors reel in cash and pay back debt:Heads I win, tails you lose.

So while many are calling the market-bottom for junk bonds, I’m expecting to see new historic lows on a regular basis. New historic low yields would bode very well for investors in junk bond ETFs.

HYG and the SPDR Barclays Capital High Yield Bond ETF (JNK), by far the two most popular junk bond ETFs, would be obvious winners if the picture painted above proves correct.

It is certainly worth noting that two serious factors loom heavily over the fate of junk bond ETFs:the Federal Reserve, and default.

If macroeconomic conditions play out in a doomsday scenario, defaults in the junk bond market could spike dramatically and cause investors to demand higher yield in a heightened risk-off environment.

Another important note on default risk is that issuers of low-rated debt may overextend themselves in good times. Consequently, they face a higher risk of default when the economic environment turns negative. However, the number of companies that have overextended themselves in this market ought to be limited.

The American economy has hardly been robust at any point in the past five years, and most at-risk firms have assumed a defensive posture that should fare well, even in a tough environment. This defensive posture is highlighted by the Federal Reserve’s most recent “flow of funds” report that showed at the end of March, companies were holding a record-breaking $1.74 trillion in liquid assets, nearly double the level from a decade ago.

Also, if the Federal Reserve reneges on its commitment to suppress long-term rates, investors who were previously deterred by negative real rates may find their way back to the relative safety of Treasurys. As money flows back into Treasurys, demand for junk bonds wanes, and investors demand a greater premium over the rate offered by risk-free Treasurys. Although this is a possibility, it’s unlikely, as recent debate has centered on extending the low-rate pledge rather than curtailing it.

Both default risk and interest-rate risk are always present in the junk bond market but, in my opinion, current conditions abate both risks.

Ultimately, there is no such thing as a free lunch. Investing in junk bond ETFs presents its own set of risks and rewards, but this analyst-turned-blogger believes that junk bond yields are headed in one direction:down.

At the time the article was written, the author had no positions in the securities mentioned. Contact Spencer Bogart at sbogart@indexuniverse.com .

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