By Robert Barone and Dustin Goldade
The latest craze is through the junk bond market, where income starved investors are taking on more risk to generate only small amounts of yield. However, the mounting risks in the junk bond market are substantial relative to the return. The yields in that bond market are not only way below historic norms, but also below their historic default rates.
This means that junk bond investors should expect losses if they are in the market for the long term. Although default rates are low at the moment, junk bond issuers are highly cyclical and will be the first to crack when interest rates rise. The junk bond market is a trend, not an investment.
The Risks in the Bond Market
Market pundits are very focused on the potential of rising interest rates. Looking at the junk bond market, not only are there significant headwinds in terms of such interest rate risk but there are also default risks that investors need to be compensated for but are now ignoring.
The table below shows historical data on default rates on junk bonds, which highlights the looming concerns in this market.
Source: Standard and Poor's, St. Louis Federal Reserve
The real concern the table points out is in the B-rated and lower bond categories, where the average default risk is higher than the yield and where investors have been reaching for yield. Although default risks are now towards historic lows due to the Federal Reserve's zero interest rate policy (ZIRP), default rates are likely to revert back to their historic averages.
For example, if default rates return back to their average of 7.28% for B-rated paper, the current 10-year yields of only 5.88% will generate a loss for the holders of these bonds. Investors should expect yield spreads to widen on these bonds as ZIRP ends.
Feast or Famine
Another alarming issue the table points out is the standard deviation and the maximum default rates of junk bonds. When looking at the actual historical data, it becomes clear default rates for these bonds are lumpy.
During years of strong economic growth, default rates are very low, around 0% to 3%. However, during times of economic troubles, default rates spike. For example, default rates on B-rated bonds between 1990 and 1992 averaged 14.5%; between 1999 and 2002, they averaged 11.6%.
The junk bond market is priced to perfection. Think about the new issuances of 10 year B-rated bonds which yield only 5.88% on average. Such bonds have 10 years to experience a more" normal" economic environment. Over the life of the bond, it's almost inevitable that default rates will return to their historic levels which are higher than their current market yields and resulting in a negative rate of return.
In addition, the odds of a recession over the next 10 years are also very high. We haven't had one in five years, and default rates for junk bonds during recession are typically in double digits. These bonds assume persisting abnormalities in the economy; this is a lot of risk for only a six percent yield and a very limited upside.
Swim at Your Own Risk
Betting on continued euphoria is hardly an investment strategy.
Climbing the rational hurdles associated with having a bullish outlook is difficult and relies on hot money inflows, i.e., the next greater fool, rather than on long term fundamentals. The risks associated with rising interest rates alone are enough to deter many seasoned investors from the bond market in general.
But of greater import, the current market fails to recognize inherent credit risk. The combination of high interest rate risk and unpriced credit risk puts the junk bond market squarely in bubble territory. Even Fed Chair Janet Yellen acknowledged this in her recent testimony before Congress.
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At the time of publication the author held no positions in any of the stocks mentioned.
This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.