Should Investors be Looking at High Yield Bonds?

The one thing we know for sure about the economic environment at the moment is that it is unusual, maybe even unique. The relatively rapid rise in interest rates off of historically low levels is something that we have not seen before and, so far, the impact has not been what theory suggested or most expected: Unemployment is still below four percent, suggesting a tight labor market, house prices have risen sharply, not fallen, and corporate profits, while lower than a year ago, are holding up better than anticipated, as evidenced by an even higher than usual percentage of earnings beats so far this season.

It makes sense, then, for investors to look at areas of the market that, in theory, should be suffering and have been sold off as a result but are, based on current conditions, cheap at current levels. One of those would be high-yield corporate bonds. In theory, they are one of the worst possible investments in a rising or relatively high interest rate environment for two reasons.

First, high yields on corporate bonds are demanded by investors when they perceive high credit risk, so they are generally sold when economic conditions are deteriorating or are expected to do so. The expectation is that even a small downturn will put pressure on these already vulnerable companies, and the number of defaults among high yield bonds, which makes those individual bonds essentially worthless, will rise significantly. That is why high yield bonds are also known as junk bonds.

Second, higher yields available from higher rated bonds, up to and including Treasuries, which the market sees as the “safe” investment, mean higher yields on lower quality bonds. With bonds of any kind, higher yields mean lower prices, so as rates on high yield climb to maintain a spread against higher quality, prices fall.

Over the last couple of months, the market has come to terms with the fact that the Fed isn’t about to cut rates any time soon, and probably hasn’t finished with hikes either. That realization has made the chart for things like the SPDR Bloomberg High Yield Fund ETF (JNK) for the period since the beginning of September look like this:

That is hardly an inspiring look, and if the Fed does raise rates even more and keeps them “higher for longer” as most now think they will, then logically, we can expect more of the same for several months at least.

However, as mentioned above, much of the logic and conventional wisdom that has been assumed over the last year and a half or so has not panned out, and that is true in high yield just as much as elsewhere. Yes, defaults have increased but they too have done so from what were, historically speaking, very low levels, and they are still below long-term averages at just below 3%. Defaults obviously cause losses in funds like JNK, but the yield available in these bonds offset those losses to some extent.

That yield, right now, is running at around 9%, double the roughly 4.5% decline in price over the last couple of months, and more than offsetting even the 6.7% drop from the 52-week high in JNK from back in February. Of course, that doesn’t matter if you believe a harsh recession is coming sometime soon, but if you believe a “soft landing,” where growth slows but doesn’t turn negative and inflation falls to the Fed’s target 2% level, is likely, then a 9% yield is very attractive.

The desirability of high yield largely depends, as do most things in investing right now, on your view of the future. However, a 9% yield covers a lot of problems, and beginning to lock in returns at those levels by averaging a portion of their money into something like JNK makes sense for a lot of investors, particularly those who will soon transition to seeking income rather than growth from their portfolio.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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