As recently as mid-2007, investors could earn more than 5 percent on ultra-safe Treasury bonds. Today, they have to venture into junk-bond territory to find a similar yield, and plenty of people are making that journey.
Mutual funds investing in high-yield bonds – the polite name for junk – have raked in nearly $50 billion of new cash so far this year. That has pushed yields to record low levels, which has caused some analysts to declare that a junk-bond bubble is inflating.
In the bond world, all rates are relative. The average junk bond yield, according to the Barclays High Yield Index, is 6.65 percent, which is exactly 5 percentage points more than the yield on a 10-year Treasury note.
That spread compensates investors for the extra risk they take in lending to a company like Charter Communications, which emerged from bankruptcy less than three years ago. Charter issued new 10-year bonds this summer that pay 5.25 percent, replacing older debt that carried double-digit interest rates.
Charter was part of a refinancing wave that has pushed junk-bond issuance to $200 billion so far this year, which is on pace to break a record set in 2010.
The question is, are investors in junk-bond mutual funds stretching a little too hard to find a 5 or 6 percent yield? Larry Swedroe, research director at Buckingham Asset Management in Clayton, thinks people have forgotten the lessons of 2008, when junk-bond funds lost at least 25 percent of their value.
“The problem is, investors often confuse yield and return,” Swedroe says. “It's not the level of rates that matters, but how these things correlate with other assets in your portfolio.”
When stocks and other risky assets are crashing, junk bonds tend to blow up, too. Therefore, Swedroe explains, they have little diversification value.
It's a big concern, then, when junk bonds become the mutual fund flavor of the month. The investors chasing 6 percent yields today are probably some of the same people who vowed to take less risk after the crash of 2008.
Some bond-market pros, though, are less worried. “I wouldn't call it a junk-bond bubble any more than you could call all fixed-income securities a little stretched right now,” says Brian Rehling, chief fixed income strategist at Wells Fargo Advisors in St. Louis. He says the spread between junk and Treasury rates is only slightly below its long-term average.
“The value is close to fair value,” he says. “It is not a cheap asset class by any means, but it doesn't look overly expensive either.”
In today's market, Rehling says, he'd rather see someone stretch for yield by buying a junk bond than by reaching for longer maturities, like a 30-year Treasury bond. Thirty years is much too long to lock in today's unusually rates, he says, and junk bonds typically have maturities of 10 years or less.
That said, Wells Fargo doesn't advise anyone to put all, or even most, of their eggs in the high-yield basket. For people wanting a moderate growth and income allocation, the firm puts just 6 percent of their money in junk bonds.
If you're a do-it-yourself investor, consider that a maximum. And unless you're an aggressive risk-taker, it's best to avoid high-yield bonds altogether. The category's nickname seems lighthearted enough when things are going well, but in the next downturn, investors will remember that they call it junk for a reason.