Everyone knows stocks are for growth and bonds are for safety. But there’s an investment that combines the worst qualities of both, and it has long confounded portfolio managers.
I’m referring to high-yield bonds, better known as junk. Most portfolios hold “risk” assets such as public or private equity, tempered by “non-risk” assets such as high-quality bonds. Junk bonds don’t fit easily into that structure because they generate a lower long-term return than risky investments but are far riskier than safer ones. Thus the dilemma: Adding junk bonds to the risk portion is likely to be a drag on growth while including them in non-risk undermines safety. Neither option is appealing.
I was reminded of this by Norway’s recent announcement that its $1 trillion sovereign wealth fund will reduce its allocation to high-yielding emerging-market bonds after increasing its allocation to equities in 2017. Like any investor, Norway has its own specific reasons for the moves. But the undeniable result, which the fund no doubt considered, is a higher long-term expected return from its risk assets and more safety from its non-risk ones. Junk bond conundrum averted, or at least ameliorated.
For high-yield bonds, there’s always a danger that investors will sidestep thorny questions about their place in portfolios by excluding them altogether. And now would be a bad time for an exodus because junk bonds’ recent surge in popularity leaves investors unusually vulnerable.
The numbers don’t help the case for junk bonds. For starters, they are far riskier than high-quality bonds. The Bloomberg Barclays U.S. Corporate High Yield Bond Index has been twice as volatile as the Bloomberg Barclays U.S. Aggregate Bond Index since July 1983, as measured by annualized standard deviation. The high-yield index has also been more volatile than the aggregate bond index during every rolling 10-year period, counted monthly.
At the same time, high-yield bonds struggle to keep up with other risky investments. The S&P 500 Index, for example, has outpaced the high-yield index by 2.1 percentage points a year since July 1983, including dividends. The S&P 500 has also beaten the high-yield index 65 percent of the time over rolling 10-year periods.
Nor do junk bonds offer much diversification because they’re highly correlated with stocks. The monthly correlation between the S&P 500 and the high-yield index has been 0.59 since July 1983. And that correlation is rising. The rolling 10-year correlation has hovered around 0.7 in recent years, up from 0.5 during the previous two decades. (A correlation of 1 implies that two variables move perfectly in the same direction, whereas a correlation of negative 1 implies that two variables move perfectly in the opposite direction.)
The results are similar when looking at other types of publicly traded junk bonds, such as high-yield municipal and emerging-market bonds. But none of that has dissuaded investors. Roughly $500 billion is invested in high-yield mutual funds and exchange-traded funds, according to Morningstar data, including municipals and emerging-market bonds.
Investors can’t seem to get enough, as evidenced by historically low yields. The yield spread between the high-yield index and the Bloomberg Barclays Intermediate U.S. Corporate Index is 2.9 percentage points, which is among the lowest on record and nearly half the average of 4.4 percentage points since 1990.
As others have pointed out repeatedly, investors have chased junk bonds since the 2008 financial crisis as the Federal Reserve’s zero interest-rate policy sent them scavenging for higher yields. Investors have been blessed with what is soon to be the longest economic expansion on record, which has kept default rates low and junk bond prices stable.
But it’s hard to imagine that their luck can last much longer. If the economy continues to grow, the Fed will eventually resume raising short-term interest rates, further squeezing the yield spread and daring investors to dump junk bonds. And if the economy stumbles, defaults will spike and junk bond prices will tumble.
Junk bonds have been there before. In September 1997, the yield spread fell to 2.1 percentage points, a record low at the time. During the five years that followed, the yield spread widened to 8.7 percentage points and the high-yield index declined 39 percent. By May 2007, the yield spread had narrowed again to a new record low of 1.8 percentage points. This time it deflated more quickly, but just as drastically. The yield spread widened to 13.4 percentage points by November 2008, and the high-yield index dropped 42 percent.
Against that backdrop, the current yield spread of 2.9 percentage points should make even junk bond enthusiasts uneasy. It wouldn’t take much to send them tumbling again — perhaps just a few more investors deciding that junk bonds don’t quite fit in their portfolios.
Nir Kaissar is a Bloomberg Opinion columnist covering the markets. He is the founder of Unison Advisors, an asset management firm. He has worked as a lawyer at Sullivan & Cromwell and a consultant at Ernst & Young.
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