4 Reasons the Junk Bond Rally Will Continue in 2013

junk bond market 1Earlier this month, the yield on the average junk bond dropped below 6% for the first time ever.  Because of this, many investors think that yields can’t go any lower and that interest rates will reverse in 2013.

Here’s four reasons why they are wrong:

Reason number 1: Junk bond credit spreads are not anywhere near all time historical lows.

In addition to the interest rate a particular type of bond (ie. high yield, investment grade etc) is paying, bond traders will look at how that rate compares to treasuries.  This comparison enables traders to understand if a category of bonds is expensive or cheap given the current level of overall interest rates.

The below chart shows the difference in yield between the average high yield bond, and a treasury of the same maturity.  This is what is known as the high yield credit spread.

high yield bubble

As you can see from the above chart, while junk bond yields are at all time lows, the high yield credit spread is nowhere near an all time low.  In fact, there were two extended periods of time since 1996 (which is as far back as the Fed’s data goes), that the high yield credit spread was around 2.5%.  This means at its current level of 5%, the high yield credit spread would have to drop another 2.5% before hitting a new all time low.

 

Reason Number 2: Corporate Default Rates are near an all time low

As you can see from the below chart, the average default rate on corporate bonds is around 4%. That compares to the current default rate of around 1.1%.  So, while junk bond yields are at historic lows, so is the corporate default rate.

corporate default rates

 

Reason number 3: Yield starved bond managers are going to start to leverage up.

This one I got from a recent presentation by bond guru Jeffrey Gundlach.  In his view the Junk bond market is not yet in a bubble.  Normally, a bubble is partially caused by investors increasing their leverage, which has not yet happened.  He does think however that bond managers are going to start adding leverage to try and juice whatever yield they can out of this low yield environment.

When this happens it will have the same effect as if a lot of new money and demand was coming into the market.  While this will likely inflate a junk bond bubble in the future, it is likely to send yields even lower in the near term.  A recent article in the Wall Street Journal confirms that this is already starting.

 

Reason number 4: Everyone thinks there is a bubble in junk bonds.

Learn Bonds publishes a piece called The Best of the Bond Market, where we link to all the best bond market stories from around the web each trading day.  There have been so many stories about the “bubble in junk bonds” that I have had to tell the writer to start leaving some of them out.  If we included them all then half the stories in the piece would be the same story calling for a bubble in junk bonds.

From my experience when everyone thinks a market is going to go in one direction, that market has a nasty habit of heading in the exact opposite direction.

What do you think?  Let us know in our new forum or in the comments section below.  

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Comments

  1. says

    Your reason #3 is the only valid one. Spreads are function of yields, which are a function of prices.  Prices for high yield are constrained by their call provisions, warping the spread relationship.

    Second, defaults are a trailing indicator, and thus not valid for forecasting the future.

    Third, yes, we need to see more leverage on bonds before this is done.  But we are seeing an uptick in corporate leverage and CDO creation, so leverage isn’t totally gone.

    Fourth, it doesn’t matter what people think; it matters what they are economically relying on.  Right now, there are a lot of novice investors relying on the idea that bonds with above average risks will not destroy their retirements when the credit cycle turns and/or when Fed policy finally shifts.  Could be a toxic cocktail.

    Go ahead and pick up nickels in front of a steamroller.  Personally, I will wait for a better day to buy.

    • says

      Hi David,

      Thanks for the comment.  Let me start by saying that I admire your blog and do not pretend to have your level of experience or knowledge.   

      Regarding my point number 1 I did not think about the spread being warped by call provisions so point taken.  

      Regarding defaults I disagree that the current default rate is not valid at all for forecasting the future default rate, especially when talking about just the next 12 months which is what my article is about.  Am I assuming that the default rate is going to be low in the future just because it is low today?  No,but I am saying that we are starting from such a low base that even if the default rate rises significantly we would still be below historical norms.  With that being said it should also be obvious from that same chart that when the default rate spikes it spikes quickly.  

      I stand by my fourth point as well.  I bet you would point to it as a sign of how frothy things have gotten if there was an article every day talking bout how much of a buy bonds are right.  Why isn’t the reverse true as well then?

      Best Regards,Dave 

      • says

        Fair points.  Let’s see what happens.  I appreciate your site; thanks for bringing it out for people to learn bonds.  As the first guy who taught the bond market said, “It takes two to make a market.”

        I’m getting most of my yield from emerging market sovereigns these days, with most of the portfolio in short-dated bonds, FWIW.

        • says

          Thanks Dave hope to see you around more.  Its interesting you say that about emerging market sovereigns, we were doing some research on the total return fund recently and notice he is holding a lot of short dated Mexican debt.  

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