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HomeMarketJunk Bonds Now Yield Over 8%. They’re Worth a Careful Look

Junk Bonds Now Yield Over 8%. They’re Worth a Careful Look

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High-yield bonds have struggled alongside most of fixed income amid a spike in interest rates from the Federal Reserve. The question now: Is it time to dip in?

Thanks to the spike in rates, investors can clip coupons with attractive interest; high yield now pays around 8%, on average. Recession risks abound over the next year, however, so it makes sense to stick with higher- quality junk, rather than chasing a little extra income from bonds lower on the ratings spectrum.

“It’s a nice, clean asset class for investors looking to generate yield,” says Ashish Shah, chief investment officer of public investments at Goldman Sachs Asset Management.

Falling prices have pushed junk yields up to an average 8.4%, based on the ICE BofA US High Yield Index. That’s nearly double the average yield of 4.35% at the end of 2021, making the sector far more attractive for income today.

The key to total returns will be whether bond prices finally cooperate. They didn’t in 2022: Prices fell sharply as rates rose, pushing down average total returns in junk to negative 10%, including interest.

Investors are now banking on bond stability as the economy and markets head into 2023. No one really knows if that will happen. And if we get a recession, which the broad bond market is signaling, defaults in junk are likely to rise, dragging down prices.

Given the risks, some bond veterans think it’s best to stick with higher-quality securities.

Martin Fridson, chief investment officer at Lehmann Livian Fridson Advisors, likes the relative safety of BB credits, the highest rating for junk. He points out that in the 12 months after yields peaked before a recession in the early 1990s, investors were better off moving up in quality and avoiding the riskiest high-yield tier, such as bonds with CCC ratings.

“In the majority of cases, it meant the difference between a negative and positive return for the period,” Fridson says, regardless of the maturity date of the securities.

Higher-quality junk bonds have already outperformed lower-rated paper. As of Dec. 2, BB-rated bonds had gained 1.8% over three months, including interest, compared with minus 1.9% for CCCs, according to BofA Research. B-rated bonds also beat lower-tier debt.

Junk bonds are getting a lift from hopes that the Fed will wind down rate hikes in the first half of 2023. The difference, or spread, in yields between Treasuries and junk hit 600 basis points, or six percentage points, in July. Spreads are now down to 450 basis points, reflecting rising prospects for a break from the Fed.

Wall Street expects a less hawkish Fed, too. “They are starting to think about a potential pause not too far from here,” Oleg Melentyev, head of U.S. high-yield credit at BofA Securities, said on Dec. 5, referring to Fed policy makers.

Scott Roth, co-head of U.S. high yield at Barings, sees the sector benefiting from healthy corporate earnings and the durability of the U.S. consumer. “We’re seeing a consumer that continues to have a fair amount of strength, driven by the excess savings and the resiliency of the job market,” he says.

Picking up extra yield by going down in credit quality might look tempting. But you have to go deep into junk land to get a big bounce. BB-rated bonds recently yielded 6.9%, compared with 8.7% for Bs, according to BofA. The yield for CCC bonds is above 15%, testament to their risk.

Investors shouldn’t expect a huge rally from here. Melentyev sees high-yield spreads staying in a range of 400 to 600 basis points over Treasuries and for the bonds to return 6% overall next year. He doesn’t foresee spreads tightening into the 300s, which would boost prices considerably. But he does see reasons for optimism, including signs that inflation is starting to come off its highs.

Granted, a key concern in high yield is defaults, which are expected to increase as the economy slows. Defaults in the BB space are still quite low, points out Roth. But Fitch Ratings projects that U.S. high-yield defaults will hit 2.5% to 3.5% next year, up from a previous forecast of 1.25% to 1.75%, “reflecting growing macroeconomic headwinds.” That would still be well below the average 10.2% during recessions since the early 2000s.

A few other factors could keep defaults from jumping sharply. Fitch expects defaults to be concentrated in sectors such as retail, telecommunications, and broadcasting/media. Earnings prospects for the energy sector—the largest issuer in high-yield—have improved, thanks to a big gains in commodity prices.

Shah, of Goldman Sachs, thinks high yield could also prove more resilient than it has in past downturns. “This is probably the highest-quality high-yield market we’ve ever seen,” he says. The growth of bank loans and private credit has removed supply from traditional high yield, which should help support prices, he adds. Furthermore, a default spike in 2020 eliminated some weaker bond issuers.

Exchange-traded funds such as the $9.7 billion
SPDR Bloomberg High Yield Bond
ETF (ticker: JNK) provide broad exposure to the market. The fund, highly diversified with around 1,200 holdings, yields about 8.5%.

Active managers who pick securities, however, could fare better as the market gets trickier. Highly rated funds, according to Morningstar, include
Angel Oak High Yield Opportunities
(ANHAX),
Buffalo High Yield
(BUFHX), and
Fidelity Short Duration High Income
(FSAHX).

RiverPark Strategic Income
(RSIVX) focuses on bonds, many of which are high yield. The fund has lost 3.6% this year, including interest. It owns debt issued by companies such as Chobani, Hawaiian Airlines, Clear Channel International, and Talen Energy Supply.

“Not all bonds default,” says David Sherman, the fund’s manager.” We’ve gone through multiple bear markets and credit cycles, and most of them do just fine.”

Write to Lawrence C. Strauss at lawrence.strauss@barrons.com

Credit: marketwatch.com

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