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For years, low interest rates have forced many investors to buy riskier assets in order to produce enough income for them to live on. But while bond buyers who've chosen yield over credit quality have been rewarded recently, signs are appearing that suggest that the good times may be ending for the high-yield bond market.
Let the good times roll
Even with the recent blips in the bond market, corporations have never had a better time to issue debt. Low rates allow companies to lock in attractive financing for years or even decades into the future. Even for creditworthy companies with investment-grade bond ratings, the low-rate environment offers an attractive profit-enhancing opportunity. Just last week, Goldman Sachs (NYSE: GS ) took the rare step of issuing 30-year bonds, while energy giants Total (NYSE: TOT ) and CNOOC (NYSE: CEO ) also issued medium and long-term debt.
Unfortunately, in the bond market, what's good for issuing companies is often bad for investors. Every percentage point a company saves in interest costs is one less percentage point of income investors receive. That has forced many investors to move toward junk bonds, which offer bigger payouts. Despite the fear in certain parts of the bond market, especially Treasuries and municipal bonds, junk bond funds have seen large inflows from investors, with nearly $1.6 billion going into the funds in just the first two weeks of the year.
Where's my reward?
Attractive rates have made junk bonds popular. But high demand is reducing the extra yield investors receive over comparable high-quality bonds like Treasuries. According to Bloomberg, the spreads for junk bond yields over Treasuries fell to just over 5.1 percentage points early this month. That's the lowest level since Nov. 2007 -- before the financial crisis started.
Lower spreads, however, won't necessarily drive performance-chasing investors away from the market -- at least not until it starts heading down. Junk bond ETFs SPDR Barclays High Yield Bond (NYSE: JNK ) and iShares iBoxx High-Yield Corporate Bond (NYSE: HYG ) returned 16% and 14.5%, respectively, over the past year, beating out most bond ETFs focusing on higher-quality credit.
Some of those gains have come from actual improvements in the financial performance of bond issuers. Over the past 12 months, the default rate on high-yield debt fell to just 3.1%. That's a two-year low and well below the 13.1% level for defaults just a year ago.
The question, though, is whether those low default rates will continue. Even with spreads at 5%, a 3% default rate still leaves a decent amount of extra yield on the table. But either rising interest rates or worsening performance among at-risk issuers could eat through that extra yield in a hurry.
A tough time for junk
As with any type of asset, junk bonds require investors to be opportunistic. When junk bonds are at extremely depressed levels, as they were two years ago, they offer the valuable combination of both very high income as well as the possibility of significant price rises if prospects for junk bond issuers improve. For instance, both Ford (NYSE: F ) and MGM Mirage (NYSE: MGM ) appeared to be on the verge of bankruptcy in early 2009, but once they got out of immediate danger, their bond prices made triple-digit percentage gains.
Once depressed issuers get out of the danger zone, though, junk bond investors don't have the same risk-reward profile that shareholders have. While shares can continue to put in huge gains, junk bonds are limited by the fact that the company never has to pay back more than the face value of the bonds. Although you'll receive nice interest payments along the way, buying junk bonds at this level doesn't give you the same potential for huge capital appreciation that you had in early 2009. And without those price gains, junk bonds aren't going to be able to duplicate their strong performance of 2010.
Mix and match
Even with the bond market facing some danger right now, you shouldn't get rid of your bond exposure entirely. What you should do, though, is look at your portfolio and make sure you aren't overexposed to junk bonds after their big run-up. By locking in some gains and moving some money to more beaten-down investments, you'll have a better chance of seeing continued gains in 2011 and beyond.
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