By Michael Brush
High-yield debt of riskier companies is not as junky as investors believe. So these bonds have sold off too much. Consider finding a place for them in your investment portfolio: Junk bonds are now a source of decent dividend yield and potential capital appreciation – and a compelling contrarian play.
“I’ve been doing this a long time, and I think now is a very attractive time to enter the asset class,” T. Rowe Price US High Yield fund /zigman2/quotes/202439824/realtime TUHYX +0.87% manager Kevin Loome told me in a recent interview. Because of widespread fears of recession “the market assuming defaults are going to be higher than they actually will be,” says Loome, who has been analyzing junk bonds since the mid-1990s.
High yield or “junk bonds” are issues rated below BB by ratings firm Standard & Poor’s. The Standard & Poor’s credit rating scale ranges from AAA at the top to very risky C and D at the bottom. BB is where speculative-grade or junk status begins, one notch below the BBB range, which is the lowest investment-grade range. Moody’s and Fitch also rate bonds, with a similar scale though the names for ratings vary a bit.
High-yield debt now pays an 8.7% dividend yield overall, but the total return potential will be much greater if prices for junk bonds rise from here. That’s likely, for five reasons described below.
Loome particularly favors lower-rated CCC bonds, which recently paid a yield of close to 15% on average. Not only is the yield higher, but CCC bonds outperform when the market bounces back, he says.
How to play this market? You can consider owning high-yield exchange-traded funds or individual issues. But personally, at a confusing time like this I’d prefer a fund actively managed by an experienced portfolio manager like Loome. This is a tricky economic environment where some sectors and companies will fare worse than others. So it makes sense to have a portfolio manager working for you.
Plus, he’s overweight CCC rated bonds, the ones that stand to outperform if it turns out recession and default fears are exaggerated.
As for sector calls, he was recently overweight energy, telecom, consumer goods and retail while underweight healthcare.
His fund also pays a higher distribution yield, at 6.84%, than the iShares iBoxx $ High Yield Corporate Bond /zigman2/quotes/204471305/composite HYG +1.08% at 4.85% and the iShares Broad USD High Yield Corporate Bond /zigman2/quotes/210444147/composite USHY +1.17% at 5.94%.
Here are five reasons to consider junk-bond exposure now.
1. Junk bonds have been really slammed
T. Rowe Price US High Yield fund shares recently went for $8.05. That’s just a little above $7.95 where they bottomed out on March 20, 2009, during the 2008-2009 financial crisis. The S&P U.S. High Yield Corporate Bond Index was down almost 14% in late June. These kinds of exaggerated moves often make for good contrarian plays.
The only time in recent history that junk bonds were down more than this for the year was when they fell 26% in 2008, says Loome. Then they were up 55% for all of 2009. “As painful as 2008 was, if you just stayed invested you had a positive outcome,” he says.
“Investors who normally have no interest in high yield should be looking at this as a rare opportunity to deploy capital with strong projected returns,” agreed Bank of America, in a recent note.
This chart reveals how much high-yield bonds have been hit; it shows how the spreads between junk debt and safer Treasurys /zigman2/quotes/211347051/realtime BX:TMUBMUSD10Y 0.00% have widened this year because of recession and default fears. Bond prices fall as yields rise.
The “options adjusted spread” (OAS) tweaks the yield on junk debt to account for the impact of options built into these bonds. This means the options issuers have to call bonds at a preset price, or the option owners have to sell back to the company from time to time.
2. Fears of a deep recession are exaggerated
This chart from the St. Louis Fed shows that junk-bond prices can sink a lot more from here if a serious recession develops. Yields rise when bond prices sink as investors sell bonds due to worries about recessions and nonpayment.
But any recession that develops here will be shallow, believes Loome, and not like the recessions during 2020, the financial crisis and the early 2000s. As the chart above shows, those recessions sent junk yields spiraling as investors sold them off.
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