A five-year rally in junk bonds abruptly stalled last month. As with other higher-risk investments, investors have pulled back mainly because they worry about the end of the Federal Reserve's policy of near-zero interest rates. Investors expect the central bank to raise rates sometime next year, and that means the value of bonds currently held in portfolios will fall.
Junk, or high-yield, bonds are sold by companies with relatively high debt in comparison to their income. If yields on safer bonds like Treasurys were to climb, they would draw more investor interest. Companies selling junk bonds would then have to increase their yields to compensate investors for the higher risk. Doing so would diminish the value of junk bonds currently in circulation.
In July, those concerns hit the market, leaving junk bond investors with a 1.3 percent loss for the month. It was the worst monthly performance since
Junk-bond yields have fallen so far that many investors now feel the risks outweigh the potential return. Five years ago, the average junk bond yielded 11.5 percent. By June, the yield had dropped to a record low of 4.83 percent, according to data from the investment bank
As a result, investment advisers have become less enthusiastic about recommending junk bonds to clients.
There is often some role for high-yield bonds in investors' portfolios, but "there's a time to dial it up, and a time to dial it down," says
Cronk says junk bonds may continue to slump as the economy improves and investors push up Treasury yields in anticipation of the Fed nearing its first interest rate increase since
"The risk-reward trade-off is not that attractive anymore," says
The market for risky bonds has become more mainstream since the 1980s, when trading was dominated by
The recent outflows came as Fed Chair
Yellen told reporters in June that the market was showing evidence of "reach-for-yield" behavior, when investors focus on return irrespective of risk. One sign of this behavior is the fact that investors have been demanding less of a premium to hold high-yield debt compared to high-quality government debt.
At the start of 2012, investors received a yield premium of 6.99 percent over Treasury notes, which are widely considered to be risk-free. By June, that cushion had fallen to 3.23 percent.
Some investors say that the fall in junk-bond yields is justified because the risk of companies defaulting on their debt has declined.
Company executives have taken a more cautious approach to managing their businesses, says
"We're in an overall pretty healthy economic environment, and most of these corporations have pretty stable balance sheets," Keenan says.
The number of companies defaulting on their debt has fallen significantly since the Great Recession ended in
Investors should see the recent sell-off as an opportunity to buy, providing that defaults remain low, suggests
At the same time, investors should also expect lower returns. Junk bonds have delivered a sizzling average annual return, including interest payments, of 12.6 percent over the past six years, according to data from
"Unless you can time it really well, you're going to be better off having stayed in the marketplace, as long as you recognize that you're going to have more modest returns than you once had," Distenfeld says.
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