Low Junk Bond Yields Not Done Falling

August 09, 2012

With junk bond yields approaching historic lows, conventional wisdom may assume a bottom has formed, but it hasn’t.

 

With U.S. junk bond yields sitting at 6.33 percent and potentially headed toward a record low of 6.31 percent, it begs the question, Have junk bond yields found a bottom?

Far from it. The negative macroeconomic environment, combined with the Federal Reserve’s actions, may indicate that yields on junk bonds have nowhere to go but down.

Historically, junk bonds outperform in prosperous economic times when businesses are doing well, cash is abundant and even low-rated debt is paid off. This favorable combination usually drives yields lower, boosting junk bond prices, to the delight of junk bond investors (whether in ETFs, mutual funds or otherwise).

The opposite is also true: When the economic environment takes a turn for the negative, yields increase and prices drop as investors become increasingly concerned about the likelihood they will be repaid.

However, with the help of Federal Reserve Chairman Ben Bernanke, the latter part of this historical relationship no longer holds true. Today we are seeing near-historical lows for junk bonds amid an overwhelmingly negative macroeconomic environment.

What’s going on?

When the global macro environment turns negative, investors often respond by decreasing equity exposure and increasing fixed-income exposure, especially to U.S. Treasurys, where investors can usually secure moderate yield.

Today those yields don’t exist. The global rush to safety, combined with Bernanke’s pledge to keep long-term rates low, has brought yields so low that real long-term yields (yields minus the inflation rate) are now so low that they’re actually negative.

Nobody likes paying something for nothing. Some of the cash that would normally flow to Treasurys as the macro environment deteriorates will now find other outlets that offer real yield.

The junk bond market has certainly been a benefactor, as we have observed massive inflows to junk bond ETFs over the past year since Bernanke pledged to keep rates low. The inflows have helped drive yields lower, and the trend appears poised to persist.

The quest for yield is highlighted by the iShares iBoxx $ High Yield Corporate Bond fund (NYSEArca: HYG), the most popular junk bond ETF, which has seen $7 billion inflows since “Operation Twist” was announced by the Federal Reserve on Sept. 21, 2011.

 

HYG Daily Flows

If economic conditions do improve, you might see the rush-to-safety buying abate, but it is likely that yields on junk bonds would decline further as debtors reel in cash and pay back debt: Heads I win, tails you lose.

 

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