Given that interest rates are likely to rise further, and that junk bond valuations have declined over the last year and a half, investors may want to shop for a little junk to add to their portfolios.
The last few weeks have seen the high-yield bond market in the news for all of the wrong reasons. Third Avenue Focused Credit Fund -- a mutual fund that specialized in investing in high-yielding loans and securities issued by struggling companies -- halted redemptions. On the heels of this news, several junk bond hedge funds announced they were closing their doors. This sent shocks waves through the credit markets and prices of junk bonds plunged, leaving many pundits suggesting that this event signaled the beginning of the next financial crisis. While it doesn't appear that these events are indicative of systemic problems in the credit markets, the events serve as a not so gentle reminder that high-yield bonds are also known as "junk bonds" for a reason.
High yield bonds become very attractive to many investors when yields in the bond market are low. If an investor has a specific yield target in mind, he needs to buy lower and lower rated bonds to earn that yield when market interest rates are particularly low. Junk bonds also become attractive when investors' aversion to risk decreases. We recently experienced the perfect storm in that investors were more and more willing to accept credit risk in a historically low interest rate environment. And, it seems, the memory of the financial crisis has faded all too quickly for many market participants.
The height of absurdity may have been reached in the middle of 2014 when the Barclays High-Yield Bond Index was yielding less than 5%. To put that into perspective, from 1926 through 2014, data compiled by Ibbotson Associates showed that long-term and intermediate-term government bonds returned 5.7% and 5.5%, respectively. Amazingly, investors were willing to accept the higher risk of junk and receive less than what default-free government bonds had returned, on average for 89 years. This new, low interest rate environment was tabbed by many as "the new normal." (Do yourself a favor and immediately run away as fast as you can when you hear something described as "the new normal" or "this time is different.")
Investors have been learning the hard way that reaching for yield can be hazardous to your wealth. The second half of 2014 saw high yield bond indexes give up ground and that losing streak has continued in 2015. The sector has fallen so far out of favor that now indexes such as the S&P U.S. Issued High Yield and Merrill Lynch High Yield are quoted at yields of 8.6% to 8.9%. Rationality, it seems, is returning to the high-yield market.
What does the recent Fed rate hike mean for junk bonds moving forward? If one assumes that the Fed rate hike signals that the central bank is going to be entering a restrictive monetary policy period, then looking at historical returns may be illustrative. In Invest With the Fed, my co-authors Gerald R. Jensen from Creighton University, Luis Garcia-Feijoo of Florida Atlantic University and I looked at how junk bonds fared in expansive and restrictive monetary policy environments. Like equities, junk bonds had higher returns in expansive monetary environments -- that is, when rates were falling -- and lower returns when rates were rising. From 1983 through 2013, a diversified portfolio of junk bonds returned 12.4% in expansive environments and 8.5% in restrictive environments. Now may be the right time for investors to consider adding junk bonds to their portfolios. It may take courage to do so in the current environment, but investors may want to heed the advice of Warren Buffett. The Oracle of Omaha has been known to say "be fearful when others are greedy and greedy when others are fearful."