Faced with persistent, ultra-low interest rates, income-seeking investors have been plowing money into high-yield bonds, also known as junk bonds. These riskier assets did well in a rising stock market and low rate environment.
But the Federal Reserve wants to raise interest rates, with the next increase coming perhaps as early as September, and that could spell trouble for high-yield bonds. Some market watchers say if defaults in high-yield bonds pick up, they could put a damper on the stock market, which is perched at an all-time high and ripe for a correction.
“The key driver will be what happens with interest rates,” says Isaac Braley, president of BTS Asset Management and a member of the firm’s investment committee in Lexington, Massachusetts.
[See: 8 Tips for Bond Investors Watching Rising Rates.]
For now, most market watchers who follow the high-yield sector aren’t too concerned about the health of junk bonds because an economic recession doesn’t seem imminent, but they are keeping an eye on valuations and spreads, both of which could signal trouble ahead. Because many experts believe high-yield bonds often lead the stock market, any weakness with them also could mean an impending decline in stocks.
Valuations. The yield on the 10-year U.S. Treasury note is around 2.37 percent, versus around 1.5 percent a year ago. While the yield is up, historically it remains low, continuing to push investors to high-yield securities.
Braley says investors are putting too much money into the sector, and as a result the yield spread between high-yield bonds and U.S. Treasury notes is narrowing sharply, especially considering the amount of risk high-yield bond investors are assuming.
Recently, seven- to 10-year junk bonds were yielding about 6 percent, which is only a little more than 400 basis points higher, on average, than the yield for similar Treasury notes.
Any yield below 6 percent becomes relatively unattractive for high-yield bonds, Braley says.
Because of the great demand, many high-yield bonds trade at 98 percent of their par value, whereas normally they’re likely to be deeply discounted, he says. That means investors are not getting much potential for prices to increase as the bonds mature.
Both the high yield and price should be attractive, he says, adding that “when you’re only getting the yield component, you have to pay attention to the risk of the asset class.”
[See: 10 Long-Term Investing Strategies That Work.]
The universal concern with high-yield bonds is valuation. Rahim Shad, a high-yield analyst with Invesco in Atlanta, says there isn’t much new debt issuance, and as a result, demand for the bonds is much higher than supply.
Tight spreads. The backdrop for high-yield bonds has been fairly benign, and consequently, Shad believes people worry less about the credit risk in these bonds and more about the risk posed from the Fed raising rates.
“High-yield traditionally has been able to cope, especially over a longer period, because you’ve got that spread cushion that can absorb a greater move,” he says. “I think the bigger concern really is not so much around rates rising, it’s really around the shock or the pace of this increase.”
But tight spreads mean less cushion. And surprise moves can buck the market, which is what happened during 2013’s “Taper Tantrum,” when U.S. Treasury yields rose as the Fed tried to gradually end quantitative easing, catching people off guard.
“As long as the rise in the rates is measured, well-communicated and slow, and as long as it’s supported by a better economic backdrop, I think it will have less of an impact on high yield,” he says.
Measured increases in interest rates and a relatively firm economy could keep default rates low, says Chun Wang, senior analyst at The Leuthold Group in Minneapolis. If so, the effect would be too minimal to be felt in an overheated stock market.
Wang’s firm is neutral on the high-yield sector, but, he says, investors also should remember the current bull market in high yield is about eight years old and the credit cycle could begin to turn.
Warning signs. Because he sees no imminent recession, Wang is not too concerned about cracks in the high-yield market, but he is watching financial conditions for warning signs. Changes in financial conditions caused credit weakness in 2015 and hurt the sector, he says.
On his watch list is the behavior of the U.S. dollar and real interest rates, which is the nominal interest rate minus inflation. The recent weakness in the dollar is a good sign, Wang says. Softer inflation is a bit of a disappointment, but The Leuthold Group is not concerned about deflation, he says.
Braley will be watching if defaults pick up as the Fed slowly raises rates, which he says would be a sign of trouble.
Shad says sentiment is important, as are the types of deals that come to market in the future. Fewer or low-quality deals could prompt market participants to wonder whether there is a market top, and investors might push back by demanding greater risk premiums, which may be another worrisome sign, he says.
Plus, other factors, such as the global central banks’ monetary policy and potential changes in U.S. fiscal policy, will play a role.
[See: 4 Reasons to Be Worried About the Economy.]
“Those are pretty major drivers of the economy over the next several years,” he says. “A lot of those things we can’t unfortunately control but could have a substantial influence in years to come.”
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Watch High Yield Bonds for Signs of a Stock Market Decline originally appeared on usnews.com