Opinion: Here’s why you should buy junk bonds now: Attractive dividend yield and big upside potential

High-yield debt from the riskiest companies isn’t as junky as investors think. These bonds therefore oversold. Consider finding a place for them in your investment portfolio: junk bonds are now a source of decent dividend yield and potential capital appreciation – and a compelling contrarian game.

“I’ve been doing this for a long time, and I think now is a very attractive time to enter the asset class,” T. Rowe Price US High Yield fund TUHYX,
+0.62%
manager Kevin Loome told me in a recent interview. Due to widespread recession fears, “the market assumes defaults are going to be higher than they actually will be,” says Loome, who has analyzed junk bonds since the mid-1990s.

High-yield bonds or “junk bonds” are issues rated below BB by the rating firm Standard & Poor’s. Standard & Poor’s credit rating scale ranges from AAA at the top to very risky C and D at the bottom. BB is where speculative or junk grade status begins, one notch below the BBB range, which is the lowest investment grade range. Moody’s and Fitch also rate bonds, with a similar scale although the rating names vary a bit.

High-yield debt now pays an overall dividend yield of 8.7%, but the total return potential will be much greater if junk bond prices rise from here. This is likely, for five reasons described below.

Loome particularly favors lower-rated CCC bonds, which have recently paid nearly 15% yield on average. Not only is the yield higher, but CCC bonds outperform when the market rebounds, he says.

How to play this market? You can consider owning high-yield exchange-traded funds or individual issues. But personally, in confusing times like these, I would prefer a fund actively managed by an experienced portfolio manager like Loome. This is a tricky economic environment where some sectors and companies will fare worse than others. It therefore makes sense to have a portfolio manager at your service.

Additionally, he is overweight CCC-rated bonds, which should outperform if the recession and default fears are overblown.

Regarding sector calls, he has recently been overweight energy, telecommunications, consumer goods and retail and underweight healthcare.

His fund also pays a higher distribution yield, at 6.84%, than the iShares iBoxx $ High Yield Corporate Bond HYG,
+0.64%
at 4.85% and the iShares Broad USD High Yield Corporate Bond USHY,
+0.60%
at 5.94%.

Here are five reasons to consider junk bond exposure now.

1. Junk bonds have been heavily criticized

Shares of the T. Rowe Price US High Yield fund recently hit $8.05. It’s just a little above $7.95 where they bottomed on March 20, 2009, during the 2008-2009 financial crisis. The S&P US High Yield Corporate Bond Index lost almost 14% at the end of June. These types of over-the-top moves often make for good contrarian plays.

The only time in recent history that junk bonds fell more than that for the year was when they fell 26% in 2008, Loome says. Then they went up 55% for all of 2009. “As bad as 2008 was, if you just stayed invested, you had a positive outcome,” he says.

“Investors who normally have no interest in high yield should view this as a rare opportunity to deploy capital with strong projected returns,” Bank of America agreed, in a recent note.

This graph reveals how many high yield bonds were affected; it shows how the spreads between junk debt and the safer TMUBMUSD10Y Treasuries,
2.923%
widened this year due to fears of recession and default. Bond prices fall as yields rise.

The “Options Adjusted Spread” (OAS) modifies the yield on junk debt to account for the impact of options embedded in these bonds. This means that option writers must buy back bonds at a predefined price, or option holders must sell back to the company from time to time.

2. Fears of a deep recession are overblown

This chart from the St. Louis Fed shows that junk bond prices can fall much further from here if a severe recession develops. Yields rise when bond prices fall as investors sell bonds on worries about recessions and defaults.

But any recession that develops here will be superficial, Loome believes, and not like the recessions of 2020, the financial crisis and the early 2000s. As the chart above shows, these recessions caused unwanted returns to skyrocket. as investors sold them.

Lily: A “false” recession? US economy doing well for now despite weak GDP

Loome cites relatively strong employment and economic activity. “We assume a recession will be shorter and shallower than normal,” agrees Bank of America, citing relatively strong corporate and consumer balance sheets. The kinds of excess leverage that caused the last severe recessions are not apparent. And the severity of COVID appears to be on the decline.

The bottom line: Loome thinks the corporate bond default rate will reach 4% in the medium term versus a long-term average and market expectations of 5%. Bank of America puts the default rate over the next 12 months at 3.4%.

3. Inflation picks up

If so, that would suggest that fears that the Fed could tip the economy into recession are overblown. That may be the case. The prices of most commodities – from oil, copper and timber to agricultural products – are all down sharply from the highs of earlier this year. A recent New York Fed survey showed that prices paid, prices received and supply chain constraints are easing for businesses. Prices for used cars, bedding and furniture, and durable goods like major appliances are all down.

At some point, that has to start showing up in official inflation numbers, says Ed Yardeni of Yardeni Research.

“It looks like inflation is starting to correct,” Loome says. This is what he hears from the leaders of the companies he analyzes. “Talking with the companies, I feel like we were at our worst a few months ago, and now it’s starting to subside.”

The bond market is saying the same thing, as 10-year Treasury yields have fallen. Breakeven rates on bonds suggest lower inflation ahead. It is the difference between the yields of treasury bills and treasury inflation-protected securities with comparable maturities.

“The bond market is very efficient. The bond market says, “We don’t think inflation is going to stay high,” says Loome.

Lily: When will inflation peak? Consumers and economists see light at the end of the tunnel (but it’s a long tunnel)

But in a way, inflation can actually help debt-issuing companies, Bank of America points out. This is because inflation can increase income and cash flow, while interest payments are usually fixed. Due to inflation, B of A expects corporate cash flow to fall only 10% in a recession over the coming year, compared to much larger declines of 25% to 40% during downturns over the past 35 years.

4. Riskiest companies have recently refinanced at low rates, pushing back the “maturity wall”

Companies have taken advantage of the low interest rates of recent years to refinance their debt. This has locked in lower interest rates which are attractive now that rates are rising.

It has also pushed back the maturity date of the debt, called the “maturity wall”. This chart from Nuveen shows that 75% of high-yield debt and loans mature after 2025.

Nuvean


“This not only mitigates the impact of any increase in interest charges, but also helps companies avoid large principal payments,” says Saira Malik, Chief Investment Officer of Nuveen. “We don’t expect delinquencies to increase significantly even in a recession because the debt burden is not excessive and low funding rates have been locked in.”

5. Liquidity is bad, but it can subside

One of the reasons high yield debt has been hit is that the markets are tight. The brokerage only creates high-yield debt markets if it issues new junk bonds. This is not the case now; the new schedule of emissions has been decided.

“Brokerage liquidity provision is several times worse than 2008,” Loome says. “Their liquidity provision is non-existent.”

Liquidity problems are particularly severe for CCC-rated bonds. This is one of the reasons why their prices have fallen so much and why Loome is overweight this part of the junk bond market.

What could go right

This liquidity problem would ease if the new issue market opens again, as recession fears ease, inflation eases and the Fed eases rate hikes.

But the problem for investors is that by the time these changes signal it’s time to return to high-yield debt, most of the junk bond price rally will have taken place.

Michael Brush is a columnist for MarketWatch. At the time of publication, he had no position in the stocks mentioned in this column. Brush is the author of the stock newsletter, Brush Up on Stocks. Follow him on Twitter @mbrushstocks.

Garland K. Long