High-yield bonds, also known as junk bonds, staged a surprising recovery to close out May as investors jumped on the opportunity to buy them at somewhat of a discount following their year-to-date decline, as shown by the below chart featuring the iShares iBoxx USD High Yield Corporate Bond Exchange-Traded Fund (HYG, Financial) and the SPDR Bloomberg High Yield Bond (JNK, Financial) ETF:
However, it may still be too early to buy the dip on these securities. Even if they are cheaper than they were at the start of the year, cracks are beginning to appear in the riskier part of the corporate debt market, indicating that liquidity issues could be in the cards after years of easy money.
Here are five reasons why investors may want to steer clear of high-yield bonds for the time being, at least until inflation cools down enough for the Federal Reserve to slow down on the interest rate hikes.
Rising borrowing costs
Historically, the high-yield bond market has shown cracks whenever the Federal Reserve begins to raise interest rates.
This time is not an exception; in fact, given the long-term downtrend in interest rates since the 1980s, one could argue that the high-yield bond market in the U.S. has never before been this close to disaster thanks to corporate America’s reliance on issuing ever-increasing amounts of debt.
That is not necessarily a bad thing. Ideally, strong companies should thrive while weak companies should go bankrupt to make way for more efficient competitors. While easy money policies have their place, they have caused a rise in so-called “zombie companies” since the 1980s, which are companies that are unprofitable from an operational standpoint and must rely on continuous new debt issuance. Some of these zombie companies are even able to issue enough debt to make themselves look profitable on paper.
Rising borrowing costs are bad for the high-yield bond market because the companies behind these bonds have junk-rated credit. Zombie companies naturally fall under this category. Companies with junk credit ratings typically need to keep issuing new debt regardless of the interest rate situation, and what’s more, they are no longer able to refinance old debt with new, cheaper debt, further worsening their balance sheets.
Liquidity issues on the horizon
Due to the increasing costs of both newly issued and refinanced debt, investors need to pay closer attention to the balance sheet strength of companies going forward. When interest rates were declining, financially weak companies had some leeway, but now that they are on the rise again, this is when we will see which ones are really struggling.
With the potential for liquidity issues, investors are much less willing to invest in high-yield debt. In general, the number of defaulting junk companies is outweighed by the gains on the rest of the high-yield bonds, but this situation can change if the market conditions are negative enough.
“Until the last week or two, we felt like this was a normal, functioning market, the liquidity premium was still low,” Rajay Bagaria, chief investment officer of Wasserstein Debt Opportunities, said in mid-May. “You are starting to see now gap-downs in price, because people just want to get out of stuff.”
In terms of fund outflows, high yield is the bond class that investors are selling out of the most so far in 2022, according to data from EPFR Global.
Yields fail to keep up with inflation
Given the increasing risks of high-yield debt, we would need to see increasing return potential in order to make these investments worthwhile, but that is certainly not the case we are seeing right now.
In fact, while yields have popped to two-year highs of approximately 7.5%, this is still below the 8.3% annual inflation rate in the U.S. as of April. In other words, high-yield bonds are currently failing to even keep up with inflation.
Granted, neither are stocks, with the S&P 500 down 13.4% year to date. However, if you are aiming to buy a dip, the benchmark index has returned an average of 14.27% per year over the past 10 years. While past results are not a guarantee of future returns, history has proven the S&P 500 to be more profitable than most other securities in the long run.
A strengthening Chinese economy
Those who have been bemoaning the supply chain hiccups stemming from China’s continued efforts to combat the Covid-19 pandemic might be feeling optimistic that the end of the lockdowns is now in sight. Even Shanghai plans to end its two-month Covid lockdown on June 1.
However, while supply chain pressures might soon ease, those whose only concern is the resulting inflation may soon find themselves disappointed. A strengthening economy is also a driver of inflation, and this is likely to be especially true coming out of the lockdown period.
In other words, we likely cannot rely on a reduction in China’s Covid lockdowns to reduce inflation in any meaningful way. The positive impact of supply chain resolutions will need to be analyzed on a company-to-company basis.
Inverted yield curve
The negative effects of rate hikes on junk yields tend to be highest when the yield curve is flat or inverted. According to a Bloomberg study, the two key slopes to look at here are the two-year/10-year Treasury slope and the three-month/10-year Treasury slope.
The two-year/10-year slope is currently flat after briefly inverting in early April, while the three-month/10-Year slope is near seven-year highs, though it has come down slightly since the beginning of May. This indicates high-yield bond returns will likely be weak relative to Treasuries.
Of course, past trends are no guarantee of future results. This is just something to take into consideration based on historical analysis.
Takeaway
High-yield bonds enjoyed an excellent run in 2020 and 2021 thanks to near-zero interest rates making other bonds practically worthless while simultaneously making it easier for companies with junk-rated credit to issue new debt and refinance old debt.
At first glance, it might look like a good time to buy the dip since these securities are down so far in 2022. However, investors may want to look into other options due to the increased risk and the yield that even now still underperforms the S&P 500’s historical average gains. When you take away the reduced risk, bonds lose a lot of their luster.
