You should think twice before investing in high-yield (a.k.a “junk”) bonds.
It’s understandable why you might be tempted to invest in such bonds. Even with the recent uptick in interest rates, U.S. Treasuries have a low yield—not enough for a fixed-income-heavy retirement portfolio to throw off much interest income. Investment-grade corporate debt yields somewhat more, but still not a lot.
Junk bond indexes, in contrast, currently are yielding as much as 4%.
The reason I think you should be very wary of junk bonds right now isn’t just that they are risky. They always are risky, due to their vulnerability to default if the economy turns out to be weaker than expected. Instead, the reason to be worried now is that junk bond yields are low relative to comparable Treasuries. That means that you earn little extra compensation for incurring junk bonds’ substantially higher default risk.
Right now, the yield spread between junk bonds and Treasuries is 3.51%, according to the ICE BofA US High Yield Index Option-Adjusted Spread (a.k.a “high yield spread”). That’s more than 2 percentage points lower than this spread’s last-two-decade average, indicating that junk bond investors collectively are betting that junk bond default risks are well below average right now.
My gut tells me just the opposite. It is by no means guaranteed that the pandemic will soon be over and the economy will kick back into gear. There are a lot of things that could go wrong, any one of which would sabotage the anticipated economic recovery.
To be sure, it’s always dangerous betting that you’re right and the market is wrong. But in this case I have history on my side. Over the past several decades, there has been an inverse relationship between the high yield spread and the subsequent junk bond default rate. In other words, default risk has been higher than average precisely at those times when investors thought that it was below average—and vice versa.
This is illustrated in the accompanying table. The data for the U.S. speculative Grade Default Rate is courtesy of S&P Global Ratings Research.
|Quintile of the historical distribution since 1997||High-yield spread range||Change in U.S. Speculative Grade Default Rate Over Subsequent 5 years|
|Lowest quintile||Below 3.63%||4.11 percentage points higher|
|2nd lowest quintile||3.63% to 4.4%||2.69 points higher|
|Middle quintile||4.4% to 5.51%||0.02 points higher|
|2nd highest quintile||5.51% to 7.08%||1.93 points lower|
|Highest quintile||Above 7.08%||5.21 points lowest|
Notice the monotonic relationship between the high yield spread and changes in the default rate over the subsequent five years. I can’t think of a better illustration of Warren Buffett’s famous advice to be greedy when others are fearful, and fearful when others are greedy.
And right now is a time when we should be fearful, since the current high yield spread falls within the lowest quintile of the historical distribution. If the future is like the past, the junk bond default rate will be substantially higher than it is today in five years’ time.
It may not even take five years for this to happen, by the way. S&P Global Ratings Research is currently projecting “the U.S. trailing-12-month speculative-grade corporate default rate to increase to 9% by September 2021,” up from September 2020’s 6.3%.
This history explains why junk bond investors in the past lost a lot when high yield spreads were as low as they are now. They not only lost money because interest rates rose as defaults rose, they also lost because of those defaults themselves.
That double whammy is illustrated in the accompanying chart. Notice how the average junk bond typically performs poorly in the wake of low spreads, and performs quite well in the wake of high spreads. In fact, the two data series are almost perfect mirror opposites of each other.
So bear this in mind the next time you are tempted by the high yields currently being paid by junk bonds. If the future is like the past, you will learn to regret succumbing to that temptation.