Junk bonds are over loved. A record $32 billion was invested in this asset class last year. In the process yields dropped to their lowest levels ever, below 6%. The appeal is obvious. Burned by the great bear market of 2008, when the S&P 500 dropped 37%, many investors are determined to avoid any exposure to stocks.
Problem was, and is, that our Federal Reserve, determined to jump start our economy and reduce unemployment, has pushed interest rates down to the lowest levels seen since World War II. Investors have responded by gravitating to bonds offering the fattest yields.
This extreme inflow into junk bonds has now alarmed policy makers, with a Federal Reserve governor suggesting this is laying the ground work for systemic risk. Put another way, junk bonds may be a bubble waiting to burst.
Our advice is to avoid this asset class. The expected returns are very low compared to the current lofty prices. Yet, investors can expect stock-like volatility from these securities.
Yields Have Never Been Lower
The yield on the average junk bond crashed through 6% in January, to about 5.8%, making them "high yield" only on a relative basis. Remember, at the nadir of the 2008 bear market, junk bond yields soared to 22%. While no one is predicting that to happen again anytime soon, the value of high yield bonds could drop by 4% or more for every 1% tick up in interest rates.
Apologists for the very low junk bond yields point to Treasuries as justification. Right now junk yields 4% more than the 10 year Treasury. Unfortunately, that's much less than the usual 6% spread.
Bottom line, should the long forecast rise in Treasury yields occur, plus spreads widen to more normal ones, junk bond investors could be walloped.
Many Are Unaware of the Junk Bond Risk in Their Portfolios
The problem is compounded because many of these volatile high yield bonds and bond funds are categorized as "fixed income" on account statements.
True, junk bonds do pay out income, but the similarity with conservative fixed income stops there. Most investors associate fixed income with the portion of their portfolio that will "zig" when stocks "zag". However, junk bonds are more correlated with equities' movements than to traditional fixed income's.
Consider 2008. The S&P declined 37% in one of the worst one year performances since the Great Depression. Did bonds offset the loss? Sure, if you were in high quality bonds; the Barclays Aggregate gained 3.7% in total return.
However, if you thought your other fixed income holdings would do the same just because they were called fixed income, you were very disappointed. High yield bonds plummeted 26.5% that year, even including their income.
Bottom line: Always consider junk bonds as equity, not fixed income, when analyzing your asset allocation.
The Inevitable Popping of the Bond Bubble Will Snare Junk Bonds, Too
Fixed income has had a great bull market for 30 years. Back in 1981, 10 year Treasury yielded double digits. Over the next three decades rates plummeted, hitting a post World War II low of 1.38% last summer.
Bond enthusiasm has accelerated in the last three years. Part of the interest was spurred by the poor performance of equities since the start of the century. It was further fueled by our Federal Reserve aggressively pushing interest rates down and bond prices up. That's creating a tail wind to fixed income performance that's nearly impossible to resist. However, a cursory study of financial market history indicates that markets move in two ways. Reversion to the mean is inevitable. That spells trouble for fixed income.
Junk bonds have been along for the ride, particularly in the last three years. While the higher yields and shorter maturities may provide some resiliency, investors should be prepared for bad news for bonds generally to envelope junk bonds as well.
Default Risk Has Not Been Priced In
Why do high yield bonds have higher yields? Because there's a greater risk that the borrower fails to repay.
Historically, about 5% of high yield bonds default. However, recoveries in default average nearly 40% of principal value, for an overall loss of about 3%.
Given that the premium on junk bonds today is a low 4%, it suggests the market isn't pricing in a normal default experience, but is way too optimistic. That doesn't sound right given the state of the economy: The US GDP was negative last quarter, and unemployment edged up last month to 7.9%, by all accounts unsatisfactory.
Look at it another way. The current interest rate on junk bonds is 6%. Net out the average amount lost due to defaults and you get a figure 3% less, or just 3%. Given that you can get 2% on the 10 year Treasury, is a meager premium of just 1% worth a risk of the 26.5% loss seen in 2008?
Rising Interest Rate Risk Not Priced In
One of the biggest risks bond investors face is rising interest rates. While the calculations can be complex, the threat is easy to fathom. Bottom line, for every 1% uptick in interest rates in a year, expect junk bonds to fall 4% not including income.
The real problem is that interest rates were some 3% higher as recently as 2007. It does not seem that junk bonds would prove an effective hedge, much less a profitable investment, in a rising interest rate environment.
Inflation Risk Not Priced In
The latest inflation statistics indicate that our dollar is losing value at about 2% annually. However, that's at the low end of historical experience. Over the last 50 years, inflation has averaged 3.4% annually.
If you subtract the historical default loss experience of 3% from the junk's current 6% interest rate you see that high yielders are really not high enough yielding to overcome historical inflation.
Given the $16.5 trillion of debt now built up by our Government and our central bank's current practice of buying 80% of new Government debt issuance with mere bookkeeping entries, it does not require a lot of imagination to envision an inflationary environment far more severe than the historical average. Unfortunately, junk bonds won't be an effective hedge.
Junk Bonds Sport No Win Call Provisions
Investors often overestimate the expected return on their junk bonds because they fail to estimate the impact of the issuer's right to call the bonds before maturity. When, as now, most bonds trade at a premium to par, or the redemption price, investors must subtract the amount of the premium when calculating the expected return.
Junk bonds today frequently trade at a 5% premium to the redemption price. The period before the bond can be called is frequently five years. An investor holding a bond trading at 105 with just 2.5 years before the call date needs to subtract 2% annually from what appears to be the yield to compensate for the issuer's likely call of the bond to refinance at today's lower rates.
Junk Bonds are Not Tax Efficient
High yield bonds are tax inefficient because the interest payments are typically subject to an investor's highest marginal tax rate. For investors with taxable income of as little as $400,000 this rate can be 43.4% (39.6% plus 3.8% for Medicare taxes on investment income) for Federal taxes, plus state and local taxes.
This tax treatment is vastly inferior to those borne by most common stock investments, where the maximum Federal tax bite is 23.8% on dividends and long term capital gains. What's more, you can control the timing of the tax on capital gains by controlling the date of sale. You have no control over the tax timing on high yield bonds since you have no option to defer the interest payments.
To avoid this onerous tax bite limit your junk bond holdings to tax sheltered accounts like IRAs or 401Ks.
David G. Dietze, JD, CFA, CFP™ is Founder, President and Chief Investment Strategist Point View Wealth Management, Inc. February 20, 2013