Junk Bonds: A Primer (Investment Outlook November 2015)

  • November 17, 2015

The name does not inspire a lot of confidence.  More often than not, Wall Street prefers to call junk bonds “high yield bonds”, emphasizing the positive result of their risk characteristics rather than the negatives of their risk of default.  Junk bonds are debt instruments which nationally recognized statistical rating organizations (NRSROs), such as Moody’s, S&P or Fitch, have determined to be below investment grade.  Investment grade bonds are those rated Baa3 and above by Moody’s or BBB- and above by S&P and Fitch; anything rated Ba1 or BB+ or lower is junk.  While investment grade bonds are issued by obligors whom NRSROs believe have adequate to extremely strong capacity to make timely payments of principal and interest to bond holders, junk bonds do not carry that level of confidence.  Economic conditions have a much stronger impact on a junk bond issuer’s ability to meet its obligations: junk bonds with BB or B ratings will struggle and could default under adverse economic conditions; bonds carrying CCC to C ratings will likely default unless economic conditions improve.  Except for the possibility that the NRSROs are wrong in their assessments (it does happen), investors might well wonder why anyone would invest in junk bonds.

The most obvious and certainly the most naive reason for investing in junk bonds is for yield: junk bonds are priced to provide a yield to maturity that is considerably higher than that of investment grade bonds. In today’s interest rate environment, where Tbills yield little or nothing — in some cases, less than nothing — and ten year Treasuries yield less than 2.5%, a yield of 7% certainly catches one’s eye. But the attractiveness of that yield is based on the assumption that it will be paid. With junk bonds, that assumption is debatable. Because of the great uncertainty of junk bond returns, they should not be considered bond investments. One should not invest in junk bonds strictly on the basis of yield. Though it may seem counter intuitive, junk bonds are really much more closely related to equity investments than they are to bonds.

An equity investor recognizes a return on his investment by way of dividends and capital appreciation. There is obviously no guarantee attached to the payment of stock dividends or to a capital return on, or even of, one’s initial equity investment: if an issuing company faces economic adversity after the purchase of stock, dividends can be suspended and the stock price will decline. This is for the most part the same risk that the investor takes with junk bonds: during periods of economic adversity, payments of principal and interest will likely be delayed and/or suspended and prices will fall. The returns of both equities and junk bonds therefore tend to move in the same direction as the fortunes of their underlying companies.

At the risk of oversimplification, investors tend to sell stocks and buy bonds when they fear the economy is contracting and buy stocks and sell bonds when they believe the economy is expanding.  This rule of thumb is based on the notion that economic expansions are accompanied by higher profits and higher interest rates, while contractions are accompanied by lower profits and lower interest rates.  Stocks move in the same direction as profits and bonds move in the opposite direction of interest rates.  This broad generalization on bonds applies almost entirely to bonds of the highest quality — U.S. Treasury bonds or AAA/Aaa rated credits, for example — where the risk of default, or even of a credit downgrade, is unlikely.  The more an issuer’s ability to fulfill its debt obligations is tied to its net income, the less its bonds will be affected by changes in the overall level of interest rates.  Although junk bonds, as well as equities, are affected by changes in interest rates (through the discount rate on estimated future cash flows), it is profit growth and changes in credit quality that drive their market prices.  To repeat, junk bonds are much more like equity substitutes in their risk/return profiles than than they are like investment grade bonds.

Arguing that junk bonds are like equities in their risk/return characteristics does not mean that there aren’t significant differences between them. Junk bonds, being bonds, carry a contractual guarantee that places them ahead of stockholders for claims on the value of assets in cases of bankruptcy. Also, junk bonds, like all bonds, pay their interest obligations before dividends for shareholders. In these two respects, junk bonds are less risky than the stocks of the same issuers.
Junk bonds are also subject to liquidity constraints. Because at any point in time there are fewer junk bonds available for trade than there are comparable equities, it may take time to create a diversified portfolio of these securities. Fortunately, there are mutual funds and exchange traded funds that can mitigate this issue.

Junk bonds aren’t for everyone. We certainly would not recommend them for fixed income or short term investors. Despite their name, they more closely resemble equities than bonds and should be considered as such in asset allocation decisions. Although performance over the last five years — a period of sluggish economic growth and absurdly low interest rates — was less than half that of the S&P 500 index, the longer term performance (trailing ten and fifteen years) of junk bonds and the index was roughly comparable. Importantly, over the last five years, the volatility of junk bonds — a measure of their risk — has been about half that of the S&P 500. In terms of fundamental risk, the issuer default rate for Moody’s U.S. Speculative Grade Universe for the twelve months ending in September was 2.54%, lower than the long term average of 4.5%. Although Barclay’s projects that this rate will increase in 2016 to a range of 5% to 5.5%, due primarily to problems in the energy and mining sectors, this is still a manageable rate in the context of a well diversified mutual fund or ETF.

We recommend that equity investors consider an ETF or mutual fund dedicated to junk bonds for a portion of their allocation to stocks. Currently, the difference between the yields on junk bonds and investment grade paper favors junk bonds, even after adjusting for their higher risk. Historically, junk bonds have produced better returns than stocks during periods of when the economy was improving. If, as we believe, 2016 provides investors with an improving and perhaps accelerating economy, junk bonds should deliver a stronger and less volatile return than that of the S&P 500.

For more information about the commentary found in this newsletter, please contact a member of the investment committee.

David Thompson

Brandon Glenn

Erik Aagaard

Frank Hosse

Jed Miller

Vaughn Antley

Sam Boldrick


Not Investment Advice or an Offer
This information is intended to assist investors. The information does not constitute investment advice or an offer to invest or to provide management services. It is not our intention to state, indicate, or imply in any manner that current or past results are indicative of future results or expectations. As with all investments, there are associated risks and you could lose money investing.