Ivan Illán is an award-winning financial services entrepreneur and bestselling author.
getty
On December 31, 1996, the U.S. junk bond market (formally, B-rated high-yield corporate debt) had an effective yield of 10.01%. (Note: The historical data in this article was sourced using a professional YCharts subscription.) Fast forward to October 1, 2021, the same B-rated bonds offered a 4.65% yield — 536 basis points lower. Over the past 25 years, the U.S. has experienced three economic recessions (’00-’01, ’07-’09 and ’20), while yields on these below investment-grade bonds have fluctuated from a peak of 23.07% in Q4 2008 to a low of 4.36% in Q4 2019. Their average yield over this period has been 8.58%. With such breadth of yields across various economic conditions, for how long should investors expect high-yield debt to stay at these well-below average levels? Perhaps, it’s likely that yield mean reversion will play out in this market, as risk perception evolves.
High-yield, so-called “junk,” bonds are supposed to have a higher risk of default than investment-grade debt, which is rated BBB, A, AA and AAA. Higher risk means a greater probability that the debt issuer (in this article, a U.S. corporation) will miss an interest or principal payment before its bond’s maturity. Anything below a BBB rating gets classified as junk. B-rated bonds are two levels below BBB and one level above CCC. The typical U.S. high-yield bond fund has an average credit quality of B, in my experience, making this rating tier a relevant one to examine over time.
As many analysts and economists wonder when the U.S. Federal Reserve Bank will begin to reduce the amount of bonds it buys every month (generally termed “tapering”), bond issuers up and down the ratings spectrum hold their breath in anticipation. For all the noise that the stock market makes whenever it digests potential changes in the Fed’s monetary policy, the most direct impact will be felt by bondholders. Current Fed policy intervenes in the public markets daily, buying $120 billion in bonds each month. All that buying drives bond prices up, which keeps bond yields down (prices and yield move inversely to each other). If the largest buyer in any market backs away, there’s a new price equilibrium discovered by that market, as it hopes for a new buyer to take up the slack.
After so many years of monetary support, the U.S. has become awash in unprecedented debt, not only at the federal level, but municipal and corporate levels, too. Even though much of this debt is relatively cheap by historical standards, and shouldn’t pose a serious economic risk by itself, there’s much uncertainty as to how quickly yields will rise once the nation’s big bond buyer backs down from its market supportive activities.
The pace of increasing yields, as bond prices fall toward a new price equilibrium, will determine the challenges ahead for those in junk status. Cash-flow-challenged issuers may be faced with the unfortunate predicament of attempting to refinance debt during times of rapidly rising yields, making their risk of interest or principal payment default even more likely. The main factors to increase this risk include:
1. The junk bond market’s schedule of bond maturity dates.
2. The total par value amount of debt coming due.
3. Prevailing yield levels at the time of maturation.
Unfortunately, a perfect storm may be brewing for the bond market should one or more of these factors compound, as any one of these could be enough to send yields considerably higher.
The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation. CRN202410-1073448
Forbes Finance Council is an invitation-only organization for executives in successful accounting, financial planning and wealth management firms. Do I qualify?
Follow me on Twitter or LinkedIn. Check out my website.