The U.S. high yield bond sector, sometimes referred to as junk bonds, have been hot over the past year. This corporate debt, issued by companies with riskier balance sheets and lower credit ratings than their investment-grade counterparts, typically carries higher interest rates. In a low interest rate environment, these high-yielding notes have drawn in investors seeking to boost their returns. With a total return of nearly 15% year to date, however, this historically "risky" segment of the bond market may be overbought as spreads on their yields narrow.  This boom in junk debt has drawn concern that a correction to the downside may be looming.

High Yield Sector has Outperformed in 2016

Total Returns MTD QTD YTD
S&P U.S. Issued High Yield Corporate Bond Index 0.25% 4.59% 14.54%

Attracted by higher yields than on safer bonds, and with lower valuations than on stocks currently, portfolio managers and individuals alike have poured money into junk bonds this year. In 2016, more than a net $6.4 billion had flowed into high-yield mutual funds through the end of August, sending the sector higher by nearly 15% YTD, compared to an approximately 7% return for the S&P 500 and 4% for investment-grade bonds over the same period.

As bond prices are bid up, however, their yields decline. This narrowing of the spread between junk yields and their safer counterparts has caused some to consider this market "too popular" and some late investors may end up getting burned if a correction occurs. In fact, the premium given to these riskier securities has fallen steadily from 9 percentage points in yield earlier this year to just above 5.

 “When spreads get very tight as they are now, you’re not getting paid as much for taking on credit risk,” said Kathleen Gaffney, manager of  the Eaton Vance Multisector Income Fund. “That means your bond becomes much more interest-rate sensitive.” This sentiment has been echoed by other analysts and bond professionals including Bill Gross. If and when the Fed raises interest rates, the junk bond sector will be negatively impacted relatively more than less risky bonds.

Of course, these relatively low interest rates mean that companies that are seen as higher risks by investors are now able to borrow at a lower cost that has been historically possible. That may help improve the balance sheets of some of these companies, potentially raising their credit rating. Alternatively, it can lead to these companies borrowing in excess and making matters worse for themselves and their creditors.

The average yield for a bond in the high yield sector now is around 6.3%. For comparison, the yield on the 10-year Treasury note is 1.6%, the dividend yield on the S&P 500 is 2.1%, according to FactSet, and the yield on high-rated U.S. corporate bonds is 2.8%, according to Bloomberg.

The Bottom Line

High yield bonds have outperformed as sector over the past year as investors seek higher yields than the rest of the market can provide. These bonds, however, typically only pay such high interest rates because they pose a significant credit risk for investors and are more likely to default or go bankrupt than higher rated companies. With so many investors flocking to junk bonds, their prices have risen - pushing down their interest rates and narrowing the spread between risky and safer bonds. This has led some to become concerned that a correction in the high yield bond sector might be around the corner.

 

 

 

 

 

 

 

 

 

 

 

 

 

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