With U.S. junk bond yields sitting at 6.33 percent and
potentially headed toward a record low of 6.31 percent, it begs the
question, Have junk bond yields found a bottom?
Far from it. The negative macroeconomic environment, combined
with the Federal Reserve's actions, may indicate that yields on
junk bonds have nowhere to go but down.
Historically, junk bonds outperform in prosperous economic times
when businesses are doing well, cash is abundant and even low-rated
debt is paid off. This favorable combination usually drives yields
lower, boosting junk bond prices, to the delight of junk bond
investors (whether in ETFs, mutual funds or otherwise).
The opposite is also true:When the economic environment takes a
turn for the negative, yields increase and prices drop as investors
become increasingly concerned about the likelihood they will be
repaid.
However, with the help of Federal Reserve Chairman Ben Bernanke,
the latter part of this historical relationship no longer holds
true. Today we are seeing near-historical lows for junk bonds amid
an overwhelmingly negative macroeconomic environment.
What's going on?
When the global macro environment turns negative, investors
often respond by decreasing equity exposure and increasing
fixed-income exposure, especially to U.S. Treasurys, where
investors can usually secure moderate yield.
Today those yields don't exist. The global rush to safety,
combined with Bernanke's pledge to keep long-term rates low, has
brought yields so low that real long-term yields (yields minus the
inflation rate) are now so low that they're actually negative.
Nobody likes paying something for nothing. Some of the cash that
would normally flow to Treasurys as the macro environment
deteriorates will now find other outlets that offer real yield.
The junk bond market has certainly been a benefactor, as we have
observed massive inflows to junk bond ETFs over the past year since
Bernanke pledged to keep rates low. The inflows have helped drive
yields lower, and the trend appears poised to persist.
The quest for yield is highlighted by the iShares iBoxx $ High
Yield Corporate Bond fund (NYSEArca:HYG), the most popular junk
bond ETF, which has seen $7 billion inflows since "Operation Twist"
was announced by the Federal Reserve on Sept. 21, 2011.
,%20by%20far%20the%20two%20most%20popular%20junk%20bond%20ETFs,%20would%20be%20obvious%20winners%20if%20the%20picture%20painted%20above%20proves%20correct.%3C/p%3E%0A%3Cp%3EIt%20is%20certainly%20worth%20noting%20that%20two%20serious%20factors%20loom%20heavily%20over%20the%20fate%20of%20junk%20bond%20ETFs:the%20Federal%20Reserve,%20and%20default.%3C/p%3E%0A%3Cp%3EIf%20macroeconomic%20conditions%20play%20out%20in%20a%20doomsday%20scenario,%20defaults%20in%20the%20junk%20bond%20market%20could%20spike%20dramatically%20and%20cause%20investors%20to%20demand%20higher%20yield%20in%20a%20heightened%20risk-off%20environment.%3C/p%3E%0A%3Cp%3EAnother%20important%20note%20on%20default%20risk%20is%20that%20issuers%20of%20low-rated%20debt%20may%20overextend%20themselves%20in%20good%20times.%20Consequently,%20they%20face%20a%20higher%20risk%20of%20default%20when%20the%20economic%20environment%20turns%20negative.%20However,%20the%20number%20of%20companies%20that%20have%20overextended%20themselves%20in%20this%20market%20ought%20to%20be%20limited.%3C/p%3E%0A%3Cp%3EThe%20American%20economy%20has%20hardly%20been%20robust%20at%20any%20point%20in%20the%20past%20five%20years,%20and%20most%20at-risk%20firms%20have%20assumed%20a%20defensive%20posture%20that%20should%20fare%20well,%20even%20in%20a%20tough%20environment.%20This%20defensive%20posture%20is%20highlighted%20by%20the%20Federal%20Reserve%E2%80%99s%20most%20recent%20%E2%80%9Cflow%20of%20funds%E2%80%9D%20report%20that%20showed%20at%20the%20end%20of%20March,%20companies%20were%20holding%20a%20record-breaking%20$1.74%20trillion%20in%20liquid%20assets,%20nearly%20double%20the%20level%20from%20a%20decade%20ago.%3C/p%3E%0A%3Cp%3EAlso,%20if%20the%20Federal%20Reserve%20reneges%20on%20its%20commitment%20to%20suppress%20long-term%20rates,%20investors%20who%20were%20previously%20deterred%20by%20negative%20real%20rates%20may%20find%20their%20way%20back%20to%20the%20relative%20safety%20of%20Treasurys.%20As%20money%20flows%20back%20into%20Treasurys,%20demand%20for%20junk%20bonds%20wanes,%20and%20investors%20demand%20a%20greater%20premium%20over%20the%20rate%20offered%20by%20risk-free%20Treasurys.%20Although%20this%20is%20a%20possibility,%20it%E2%80%99s%20unlikely,%20as%20recent%20debate%20has%20centered%20on%20extending%20the%20low-rate%20pledge%20rather%20than%20curtailing%20it.%3C/p%3E%0A%3Cp%3EBoth%20default%20risk%20and%20interest-rate%20risk%20are%20always%20present%20in%20the%20junk%20bond%20market%20but,%20in%20my%20opinion,%20current%20conditions%20abate%20both%20risks.%3C/p%3E%0A%3Cp%3EUltimately,%20there%20is%20no%20such%20thing%20as%20a%20free%20lunch.%20Investing%20in%20junk%20bond%20ETFs%20presents%20its%20own%20set%20of%20risks%20and%20rewards,%20but%20this%20analyst-turned-blogger%20believes%20that%20junk%20bond%20yields%20are%20headed%20in%20one%20direction:down.%3C/p%3E%0A%3Chr%20/%3E%0A%3Cp%3E%3Cem%3EAt%20the%20time%20the%20article%20was%20written,%20the%20author%20had%20no%20positions%20in%20the%20securities%20mentioned.%20Contact%20Spencer%20Bogart%C2%A0at%20%3C/em%3E%3Cem%3E%3Cspan%20style='text-decoration:underline;'%3Esbogart%3C/span%3E%3C/em%3E%3Cem%3E@indexuniverse.com%3C/em%3E.%3C/p%3E%0A%3Cp%3E%C2%A0%3C/p%3E%3Cdiv%20id='permalink'%3EPermalink%20%7C%20'copy;%20Copyright%202009%20IndexUniverse%20LLC.%20All%20rights%20reserved%3C/div%3E%3Cp%3E%3Ca%20href=)
Don't forget to check IndexUniverse.com's ETF Data
section.
Copyright ®
2012 IndexUniverse LLC
. All Rights Reserved.