That Hissing Noise Is Junk Bonds

July 27, 2014 8:16 PM

High yield bonds (“junk bonds”) had a tough last week.  With the amount of amateur ink spilled on junk bonds the last several days, one might be excused for thinking that there is an exodus out of this asset class.  Suggesting that the current “meh…” feeling about junk bonds is the equivalent of Mrs. O’leary’s cow knocking over a lantern to start one of the world’s great conflagrations is simply ill-reasoned.  Yes, the two largest junk bond ETFs, Barclays JNK ( $JNK ) and Blackrock’s HYG ( $HYG )have sold off since the beginning of July but by less than 1.0% each.  Nothing to see here… (yet).

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Any discussion on junk bonds should be framed by the greater idea of bond returns year to date.  Sometimes a simple reflection on performance is called for – this is one of those times.

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Clearly, bonds have performed well this year on a total return basis.  In addition, over the past three months, as US economic data has somewhat stabilized, junk bonds have continued their upward trend.  The recent selloff should be considered in this broader context of generally good performance.  For example, the broader junk bond market has gained over 5.0% so far this year while the S&P 500 ( $SPX ) is up 8.24%. 

This new junk bond nervousness is a direct result of recent outflows in the asset class.  For the week that ended on July 18, it has been reported that US investors withdrew $1.7 billion from junk bond mutual funds and ETFs.  This selling pressure has also been observed globally with withdrawals from global junk bond funds totaling $4.8 billion this past week. 

What’s happening here?  Why the recent outflows?  The world has been yield-starved for the past five years and junk bonds have benefited from that market dynamic in the US, Europe and Asia.  As investors become more nervous about rising interest rates in the US and potential monetary policy drama courtesy of the Federal Reserve, it is natural for an asset class that has seen very favorable money flows since 2009 to lose a little luster. 

Let’s not get ahead of ourselves though.  The junk bond market is a $2.2 trillion market.  Yes… that’s “trillion” with a “T.”  That’s a lot of junk bonds and there is a massive amount of differentiation between the top rated junk bonds and the bottom rung of this asset class.  Top rated BB+/Ba1 junk bonds are extraordinarily different than anything associated with a C rating and that is part of the problem when talking about such a diverse asset class in monolithic terms.  One could easily reason that if the US economy does continue on a slightly better growth trajectory, the credit risk of lower rated US junk bond issuers will lessen in combination with a still very low rates environment.   The idea of a knee-jerk selling reaction if and when rates do rise might be a very good opportunity to buy “ugly” and “story” credits further down the ratings curve to take advantage of this combination of a healthier US economy and very low interest rates.

Most professional investors invest in bonds on a spread basis rather than yield or total return.  That means they are not likely to exit junk bonds anytime soon but rather readjust their exposures for increasing or decreasing spread potentials.  For the rest of the retail crowd, what matters is that juicy yield which is slightly more savory today than the start of May when the whispers of the undoing of junk bonds started to flow.  The true problem for retail investors is that junk bonds are fighting against a perception of being highly sensitive to rates and currently offering very little reward for a big risk.  That is, much of the upside in junk bonds has been delivered courtesy of the world’s central banks.  That has been priced into junk bonds already for the most part.  Thus, it is wait-and-see mode for most junk bond investors.  Panic is not warranted but that hissing noise is a small cut in a very large balloon of junk bonds which has been filled, in one way or another, by the hot air of central banks.

Disclaimer: Nothing herein shall be construed as investment advice, a recommendation or solicitation to buy or sell any security.  This is for entertainment purposes only.

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