Junk-bond funds have many charms, chief of which is their high yields. And lately, those yields have been getting higher, at least compared to ultrasafe Treasury bonds. But this might not be the best time to buy them.
And by and large, junk bond funds have held up reasonably well over time. The average junk fund has gained an average 7.3% a year the past five years, vs. 3.8% for the average intermediate-term bond fund, according to Morningstar.
And recently, the spread between junk bonds and Treasuries has been widening, says John Lonski, team managing director of the economics group at Moody’s Analytics. Currently, junk yields an average 4.90 percentage points more than Treasuries, Lonski says, up from a low of 3.22 percentage points last year. “That’s quite a jump,” he says.
A big reason for the gains in junk funds — which Wall Street genteelly calls “high-yield bond funds” — has been because the default rate has slowed dramatically since the 2008 financial crisis. In November 2009, the high-yield default rate was 14.6%, the worst since the Great Depression. It’s 2.01% now.
Unfortunately, the default rate could be headed in the other direction. Moody’s expected default rate for the next 12 months is 3.45%. Should interest rates rise in the next 12 months, it could be a one-two punch for junk bonds. Rising rates makes the bonds less attractive to investors, and rising default rates could push prices down further. “If you’re buying high yield bonds in the context of a worsening default outlook, you’re likely to get badly burned,” Lonski says.
So far, the expected default rate hasn’t risen above 4.5% — which would be a bad thing. “When the expected default rate rises in the face of a mature recovery, it’s not only adverse for high-yield bonds, but stocks as well,” Lonski says. “I begin to smell the end of the recovery.”