Junk bonds and the rate cycle
August 22, 2013 Leave a comment
August 21, 2013 10:16 pm
Junk bonds and the rate cycle
By James Mackintosh
Betting now offers much smaller margin of safety
So much for risk-free. Not only have US 10-year Treasury bonds lost almost 10 per cent since taper talk started in May, they have also been beaten by US investment grade corporate bonds (down 6 per cent) and by junk bonds (down 2.5). Look in more detail, and the inversion is even clearer: the higher the credit rating of a bond, the bigger the loss – with the lowest-rated junk only just losing money, according to Barclays’ indices.The issue here is the interest rate cycle. As the Federal Reserve has raised fears of less stimulus, investors have dumped bonds. The same pattern held in the last turn in the interest rate cycle, in 2002-2003, when junk bonds also beat higher-quality names.
Last time, junk went on to provide great returns. In the five years to the 2007 peak, investors made more than 14 per cent a year, including coupons. The S&P500 averaged only 15 per cent, with wild swings along the way.
Even as junk bonds lost out from higher rates, they gained from a lower default risk.
Could the same happen this time? Possibly. After all, bond yields are rising because investors think the economy is stronger, giving the Fed a motive to tighten policy. A stronger economy should reduce the risk of defaults.
But junk bonds offer a much smaller margin of safety now. At the start of 2003, junk traded at a yield of 9 percentage points above Treasuries. Today, the differential is slightly more than 5 points. Further, the outperformance of junk bonds since May is nothing to do with lower default risk, and all about exposure to interest rates. Thanks to higher yields and shorter maturities, junk bonds have much less duration (the time it takes to make one’s money back). Match duration with top-rated corporate bonds, and losses are almost identical.
It should be no surprise that bonds with less exposure to rising rates have lost less. But investors need to separate junk bonds from other short-duration bonds – and there’s less hope for junk in this cycle than during the last one.
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