The U.S. Federal Reserve’s meeting of its Federal Open Market Committee in September came and went without a hitch for the interest-rate sensitive bond market — even on the much riskier class of these assets known known as “junk” bonds.
Sure, the central bank signaled to investors that they can expect another hike in interest rates by the end of 2017. And yes, Fed Chair Janet Yellen indicated it will reduce its massive $4 trillion portfolio of bonds purchased under its “quantitative easing” strategy that began during the Great Recession and lasted through 2014.
But in many ways, investors in the bond market were expecting these moves.
“The Fed has been using forward guidance quite effectively to navigate expectations of the economy and the rates market,” says Matthew Bartolini, head of SPDR Americas Research at investment firm State Street Global Advisors. “It was pretty much a status quo reaction.”
[See: 9 of the Best High-Yield ETFs on the Market.]
And contrary to what some may think given rhetoric from officials in the last year or so, the status quo is for historically low rates to persist for some time even as monetary policy gradually gets tighter.
Just consider, for instance, that the 10-year U.S. Treasury bond currently yields about 2.25 percent — down from more than 2.5 percent in spring of 2017, despite continued talk of higher rates. And longer-term, the annual yield on Treasurys hasn’t been above 3 percent since 2011.
With chronically low interest rates, then, it’s no wonder investors continue to pursue high-yield bonds — colloquially known as junk bonds that typically yield north of 5 percent annually.
But should investors trust these riskier investments? Or are they useful long-term assets despite short-term risks of another interest rate increase putting pressure on the asset class?
What is a junk bond? There are generally two categories of bonds when it comes to risk — investment grade bonds, from corporations and governments in good standing with credit agencies, and the rest of the bond universe that can be called anything from high-yield to noninvestment-grade to the rather blunt label of junk bonds.
Investment grade bonds get a rating of Baa3 or higher under the methodology of ratings agency Moody’s, and BBB- under the methodology of Standard & Poor’s. Just like a consumer with a good credit score, a corporation or a government with a good credit rating gets more favorable lending terms — meaning, a more reasonable interest rate on its debt.
On the other hand, corporations in less favorable standing see are charged extra — just like someone who bounces checks and carries a big credit card balance. This is partially to cover the added risk, but also because there are simply fewer lenders competing for that account.
The big difference, of course, is that bond investors are the lender. So if you can find a riskier company to lend to but they faithfully repay debt, your initial investment yields a much higher return than if you went with a company that was a sure thing.
Of course, getting a bigger interest payment is only good if the company doesn’t default on its debt. Because if it does, you could wind up out of luck.
[See: 7 Horrendous Dividend Stocks to Actively Avoid.]
Junk bonds serve a purpose. Despite the risks inherent with junk bonds, they serve a purpose for all kinds of investors. And that’s in large part because there aren’t a lot of other options when it comes to finding yield in today’s market.
Whether you’re near retirement looking for income potential or just looking for a reliable source of annual returns to diversify your holdings, junk bonds should be part of your strategy, Bartolini says. State Street Global Advisors recommends a “strategic asset allocation” of 6 percent in high-yield junk bonds.
“From a portfolio use case, (junk bonds) are there to generate income over a substantial period of time,” he says. “From a risk-return perspective, it should be a part of your portfolio.”
It should also be pointed out that junk bond funds come in a variety of different flavors that can offer diversification to reduce your risk, as well as tactical decisions to avoid potential hangups.
For instance, State Street Global Advisor’s flagship junk bond fund is the SPDR Bloomberg Barclays High Yield Bond ETF (ticker: JNK) with more than $12 billion in assets. Right now, the fund has a yield of about 5 percent based on the last 30 days of distributions. It holds 905 bonds in the portfolio, meaning that a few could go south without sinking the value of the entire ETF. The fund has an expense ratio of 0.40 percent, or $40 per $10,000 invested.
Or in the mutual funds universe, consider the Wells Fargo Advantage Short-Term High-Yield Bond Investor ( STYIX). Its yield is lower, around 2.3 percent, because it focuses on shorter-term debt that is less sensitive to interest rate changes or market disruptions. Its expense ratio is 0.50 percent.
There are a host of other ways to slice up the junk bond universe, too, depending on your investment goals and risk profile.
Next for junk bonds. Are investors still high on high yield after the Fed, and will they stay that way into 2018?
If recent fund flows are any indication, junk bonds are still very much in favor. Bartolini points to $885 million in inflows to high-yield bond ETFs across the week when the Fed held its big meeting — a firm sign of continued demand.
But what 2018 holds is anyone’s guess. That depends on the bond market functioning as it has, without a big event like geopolitical disruptions caused by North Korea or other events that roil global markets.
“It’s not like we are in a riskless market,” Bartolini says. “There are spikes in volatility, episodes where tail risk happens and the market sells off a bit.”
Nobody can ever know for sure when those events happen, but if and when they do, Bartolini warns that riskier investments like junk bonds could see some short-term pain regardless of big-picture support for the asset class.
[See: 9 Ways to Invest in America With Bond Funds.]
“Investors need to know that with high yield (bonds) they are stepping into a more speculative space,” he said. “There’s less cushion to the downside.”
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Why Investors Seek Junk Bonds originally appeared on usnews.com
