Junk Habit Sweeps the Street

Junk bonds are all the rage these days, as investors search for high returns on investments amid stock market woes and low interest rates. So is now the time to buy? Maybe, if you can stomach the risk.

A total of $30 billion worth of high-yield corporate bonds, or junk bonds, were issued in the first four months of this year alone, compared with last year's full-year total of $59 billion, according to Thomson First Call. But with the high returns come dangers: If the economy doesn't improve and companies continue to struggle, they may be likely to default.

"Investors willing to take the risk in high yield now are assuming a large improvement in the economy and lower default rates. But some of these companies ... still face underpinnings related to pension funding, pricing power," said Diane Keefe, portfolio manager at Pax World High-Yield Fund.

Nonetheless, in March, junk-bond junkies were on a roll, with almost 70% of all flows into bond funds going into high-yield securities, according to research firm AMG Data Services.

Junk bonds, which became prominent in the '80s, offer much higher interest payments than other types of bonds, because they carry low credit ratings. Companies issue junk as a convenient way to tap the corporate bond market and raise some money. Some high-yield experts, such as Tom Huggins, portfolio manager at Eaton Vance, expect strong returns from junk bonds this year, predicting that mutual funds specializing in them will reap yields of 30% to 40% on average. So far this year, returns on high-yield funds are hovering around 10%, according to Morningstar.

Keefe at Pax World notes that default rates recently have dwindled, but if the economy continues to stagnate, defaults could start to pop up again. According to Fitch Ratings, the rate of defaults among high-yield issuers in the first quarter this year fell to $6.5 billion, or 1.1% of all the volume of bonds outstanding, from $26.3 billion, or 5%, in the same period a year earlier.

Even if the economy does recover, junk bonds could still face pressure, as experts predict that people will move back into equities, leaving junk bonds overpriced and overvalued, according to Keith Black, a professor at the Illinois Institute of Technology.

Historical data on the performance of high-yield bonds following a bear market aren't very encouraging, either. In the year following the 1987 market drop, the average high-yield bond fund rose 11.9%, below average gains of 21.5% in stock funds, according to Morningstar. Following the 1990 bear market, stock funds gained 37%, compared with just 28% for junk.

Still, some analysts say there is a good case to be made for junk bonds in the current market environment.

"With expectations of no near end to the low interest-rate cycle, I can understand why people are moving into high yield," said Louise Purtle, head of U.S. credit strategy at research firm CreditSights. Junk bonds usually outperform both equities and Treasuries in advance of an economic upturn, she said.

Even if the economy doesn't improve immediately, junk-bond optimists say, the current market has been swept clean of some of the corporate excesses of the late '90s, when many high-risk issuers defaulted on their debts.

"We are still pretty bullish on high-yield bonds," said Huggins of Eaton Vance. "People are looking at them as a safe haven, with equities still in the doldrums. There are no worries yet about rate increases, and returns are high enough to make them interesting."

Mark Durbiano, senior portfolio manager at Federated Investors, agrees. "Right now, high yield is better than other fixed-income assets, just as long as we are not getting back into a recession," he said.

So what can you do to avoid getting burned if you decide to invest in junk? Purtle of CreditSights says mutual funds with a diverse mix of junk bonds and a proven track record would be a better bet than individual junk bonds. Otherwise, for those who want to add some color to their fixed-income portfolio, she suggests a range of 5% to 8% in high-yield bonds, which she considers a relatively aggressive position.

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