The Junk-Bond Market's Best Days May Be Behind It

As small investors flee the low returns of Treasury bonds, many have piled into high-yield debt -- also known as junk bonds. Junk returns have totaled 87% in the past two years, compared with a little more than 50% for the S&P 500 stock index. Are we getting near a junk bubble?

So much money has been pouring into high yield that demand is outstripping bond issuance. The Merrill Lynch High Yield Index, which yielded 7.5% at the beginning of the year, now yields just 6.92%.

Since prices go up when yields go down, investors have made a good capital gain in addition to the interest paid. But can this go on?

"I would characterize the market as fully priced at the moment," says Martin Fridson, global credit strategist at BNP Paribas Investment Partners. "It looks like the market has gotten a little ahead of itself, and we've had a very dramatic move during February."

Why Buy Now?

At the same time, Treasury bonds have moved up in yield in the last few months, meaning the all-important spread -- or difference -- between Treasury bond yields and junk bond yields has shriveled. It now stands at 4.59%, down from 4.92% at the beginning of the year. That's near an historic low.

"I don' think anyone is really buying high-yield bonds at this point with an expectation of really substantial capital gains over the next 12 months," Fridson says. "By and large people are buying high-yield bonds because interest rates are very low."

Still, junk bonds do have some advantages in their favor. Default rates are at historic lows -- not a single bond defaulted in January, the first time that's happened since 2007. And the interest paid is still considerably higher than either Treasurys or investment-grade debt.

European junk is an even better deal than domestic U.S. high yield, paying 7.64% with a 5.14% spread over Treasurys. But that market is much more volatile than the U.S. market.

"A Bit Worrisome"

David Rosenberg, chief economist of stockbroker Gluskin Sheff in Toronto, notes that despite the falling yields, investors keeping piling in. "What is a bit scary is that inflows into high-yield funds are surging -- almost $5 billion so far this year, which is over one-third of the 2010 intake. This is a bit worrisome from a contrarian standpoint."

Sponsored Links

Timothy J. Gramatovich, chief investment officer of Peritus Asset Managment, the Santa Barbara, Calif.-based manager of an actively managed high-yield bond fund known as Advisor Shares Peritus ETF (HYLD), says the recent run-up in the market means investors have to be more picky about choosing junk bonds than they were in the past.

"The trade when you could buy anything and make money ended six months ago," Gramatovich says. "There's still spread available, but in this environment there are bombs waiting to go off. What people who are throwing money at the asset class don't understand is that it needs to be aggressively managed to limit the risk."

Gramatovich cautions investors to steer clear of legacy leveraged-buyout junk bonds, such as Texas Utilities and First Data.

"The problem companies are too highly levered, have too much debt and not enough cash flow," he says. Yet, they trade at the same low current yields as everything else.

High Yields Aren't Everything

Some small investors tend to go for the highest-yielding junk bonds, which Gramatovich also says can be problematic. "You have to be careful because there's a lot of downside in some of these names," he says. "Although the yield is good, what good is the yield if the bond ultimately defaults?"

He points out that although the entire index had an extremely low default rate of 3.1% last year, even one or two defaults can upset an entire portfolio.

What to look for in a junk-bond investment? A reasonable level of borrowing, good liquidity, a business that has a reason to exist and a recurring revenue stream. Although a rising tide raises all ships, that may work only in the short term for high-yield bonds.

Get info on stocks mentioned in this article: