Stock prices have doubled in the past three years, and everyday investors keep pulling money out of stocks. But they’re happy to lend billions of dollars to companies with deep debts and embarrassing credit scores.
They’re doing it through junk bonds, the risky investments made infamous by the disgraced investment banker Michael Milken in the 1980s. Americans have never shoveled so much money into junk bond funds to start a year.
Since the start of January, everyday investors have put $12 billion into mutual funds that buy high-yield bonds, the polite name for junk. That’s more than the $8.2 billion they invested in all of 2011. The full-year record was $28 billion in 2009.
“If the trend continues we’ll blow that number away,” says Jeff Tjornehoj, head of Americas Research at Lipper, the company that tracks mutual funds and compiled the numbers.
Buying a junk bond makes you a lender to companies with heavy debts and low credit ratings. That’s why investors demand higher returns in exchange for handing over their money.
Junk bonds still carry a lingering black mark from Milken, who pioneered the market in the 1980s while at Drexel Burnham Lambert. Milken was convicted of insider trading and violating other federal securities laws and has since remade himself as a philanthropist.
And then there’s that unpleasant name.
“A lot of people look at high-yield with a jaded viewpoint,” says Jason Pride, director of investment strategy at Glenmede, an investment management company. “They think, ‘Why would you own anything other than stocks?'”
Stocks have been on a roll. The Standard & Poor’s 500 index is up 11 per cent this year and has doubled since it hit its low point during the Great Recession in March 2009.
Professional money managers usually predict disaster when the public flocks to an investment outside of the stock market. To them, it’s often a reliable “sell” signal. If the average Joe shows up, the pros think it’s time to go.
Yet Pride is one of many money managers steering his customers to junk bonds. One reason is the lower risk: When a reckless company goes bankrupt, bondholders and other creditors still get paid.
And most people piling into junk bonds have no need to worry about the bankruptcy of any particular company. Buying into mutual funds that invest in more than 100 companies dilutes the danger of one going under.
The bigger draw is the yield. The typical high-yield bond pays 7.2 per cent. With interest rates at record lows, the benchmark U.S. Treasury security, the 10-year note, pays 2.2 per cent. It paid as little as 1.76 per cent last October.
“Think of high-yield as the middle ground between bonds and stocks,” Tjornehoj says.
Still scarred by the 2008 meltdown, Americans seem comfortable in that middle ground. They’ve bought junk bonds in such great numbers that prices have risen from as low as 91 cents on the dollar last October to a recent $1.01. That’s pushed borrowing costs down from above 10 per cent.
The main drawback is that junk bonds are among the more hazardous bond investments around. Rating agencies, using another delicate term, label the bonds “speculative grade.” They’re the candidates considered most likely to miss an interest payment and go bankrupt.
The price of a company’s high-yield bond often shadows its stock. But bondholders are better off when a company runs into trouble. In a bankruptcy, owners of high-yield bonds count as creditors, like banks, and can expect to get back around 40 cents on the dollar. Owners of stock can expect nothing.
Just two years ago, Moody’s warned that companies and the federal government faced a tidal wave of debts coming due, what’s known as a maturity wall. Forced to compete with the U.S. government for new loans, companies could wind up paying crushing interest rates and be pushed into bankruptcy. News reports imagined doomsday scenarios coming from the junk bond market and referred to the Mayan calendar and the world ending in late 2012.
What happened? “Companies kicked out the wall,” says Kevin Cassidy, senior credit officer at Moody’s.
With interest rates at all-time lows, companies managed to borrow cheaply and used the money from investors to refinance their debts. They pushed their due dates years into the future and also have smaller interest payments.
“If the Federal Reserve hadn’t kept rates as low as they kept them, and if the economy hadn’t picked up, you would have had a scarier situation,” Cassidy says.
Despite the predictions of doom, defaults remain rare. Just 2.2 per cent of companies that issue low-rated bonds defaulted in the last year, according to Moody’s. That rate will probably inch toward the 5 per cent historical average as interest rates rise.
Jack Ablin, chief investment officer at Harris Private Bank, says he understands why many of his clients are drawn to high-yield bonds. They saw stocks plunge for no apparent reason in the Flash Crash of 2010 and watched the Dow take wild swings last August. Now they’re encouraged by the slowly improving economy and willing to take a step out of cash. Buying junk is a way to stay in bonds while creeping closer to the stock market, Ablin says.
“People are sceptical of the stock market for very good reasons.”