With The Economy Sluggish Junk Bonds Require Scrutiny And History Suggests Caution
In a thriving economy, high-yield bonds (often called "junk" bonds) tend to be popular, paying high interest rates and generally outperforming the market. When the economy starts to slow, though, high-yield bonds may be among the first casualties. Now, with some economists predicting a major downturn, it's important to know how much of your portfolio is allocated to these relatively risky investments—and to consider shifting money into steadier holdings if you have too much junk.
During the past five years, the average high-yield bond mutual fund has been reliable, delivering approximately a 9% average annual return, according to fund tracker Morningstar. This run came after the last recession and a downturn for this risky class of bonds. This is not 2002, when fallout from the dot-com bust led to defaults by many companies that had issued high-yield debt. Today's high-yield companies have stronger financial positions than the vacuous internet companies that collapsed early in the decade. Still, a cautious approach seems wise.
Two factors are putting pressure on the high-yield bond market. Interest rates have moved higher over the last three of years, increasing the cost of borrowing. Meanwhile, the use of high-yield bonds in the recent flurry of mergers and acquisitions has led to monstrous amounts of below-investment-grade debt. With interest rates rising, companies with high-yield debt must increase earnings to avoid defaulting on interest payments to bondholders.
This is all part of what could become a vicious cycle. Suppose a company has acquired a competitor, using the proceeds from junk bonds to finance the purchase. Now, a heavy debt load—and a promise to pay high rates to bondholders—leaves the merged company scrambling to meet its obligations. A big chunk of profits must go toward making bond payments, making it difficult for the company to grow. What does increase is the risk of default—and the more often this scenario is repeated, the more likely the junk bond market as a whole will suffer.
The heavy debt some companies are taking on now is reminiscent of the leveraged buyout craze of the mid-1980s. In the late 1980s, high interest rates and unsupportable debt levels led to a crash in the high-yield market, as companies that never should have been extended credit received sizeable loans they simply could not repay. Rates are lower today than in 1987 and 1988, but some companies are piling on debt. If interest rates edge upward, there could be danger ahead.
A bond fund can hold up to approximately a third of its assets in bonds not suggested by the fund's name. So a "Government" bond fund could hold a significant position in junk bonds. Our firm tracks such issues to ensure that your exposure to potential high-yield problems is appropriate and that funds live up to their names. If you are concerned about his issue, please do not hesitate to give us a call.
This article is for informational purposes and is not a recommendation to buy or sell a security. Whether bonds of any type mentioned in this article should be part of your portfolio is an individual decision to be made after considering your investment needs, time horizon and tolerance for risk.