Junk-Bond Yields Top 8%. It Could Be a Good Time to Buy.

Junk bonds aren’t without risk. The ICE index had a negative total return of 12.6% in 2022 through this past Thursday, though that’s better than the 20% decline (including dividends) of the

S&P 500
index. And many investors understandably balk at buying debt of leveraged companies heading into a potential recession.

“Avoid junk bonds and junk equities,” warned Ariel Investments’ portfolio manager Rupal J. Bhansali, a Barron’s Roundtable member, at MarketWatch’s Best Ideas in Money conference on Thursday. “Risk assets” like junk, she said, aren’t the place to be now.

A counterargument is that junk-bond math looks pretty good at current levels. The yield gap between junk debt and risk-free Treasuries has widened to five percentage points from three points at the start of 2022, based on the ICE index. Now, it would take a default rate of 8%, coupled with a bond recovery rate of just 40%, to effectively match the yield on Treasuries (8% times a loss rate of 60% is nearly 5%, the current spread of junk to Treasuries). The market overall appears to be in good shape, with the default rate running below 1%, although likely to head higher.

One underappreciated plus is that more than half of the market now consists of double-B-rated issues, the highest junk rating, from solid companies such as

Charter Communications

(ticker CHTR),

Alcoa

(AA), and Ford Motor Credit, the auto maker’s finance arm. Just 10% of the market is in the most speculative triple-C category.

“Most companies should be able to withstand a soft recession. Companies took advantage of historically low rates to refinance debt and have padded their balance sheets with liquidity,’ says Dan DeYoung, co-manager of the

Columbia High Yield Bond
fund (INEAX). “The lower interest burden coupled with pushing out near-term debt maturities have given most high-yield companies increased financial flexibility to navigate an economic slowdown.”

The new-issue market is quiet as speculative companies balk at rates needed to attract investors. A high-profile financing for the leveraged buyout of software maker

Citrix Systems

(CTXS) was done recently at 10%.

Royal Caribbean Group

(RCL) sold $2 billion of debt on Thursday that included 9.25% bonds due in 2029. Other big junk deals waiting in the wings will finance the buyouts of

Nielsen Holdings

(NLSN) and

Tenneco

(TEN). Companies might not like those yields, but investors should.

Investors can play junk bonds through open-end mutual, closed-end, or exchange-traded funds, and individual issues. There is also another $1.5 trillion of so-called leveraged loans, which are privately issued senior obligations sold to institutional investors. That market also has funds and ETFs.

Many investors like the liquidity of junk ETFs, such as

iShares $ iBoxx High Yield Corporate
(HYG) and

SPDR Bloomberg High Yield Bond
(JNK), which hold some of the largest issues and yield about 8%. The

VanEck Fallen Angel High Yield Bond
ETF (ANGL), which buys corporate debt that was once investment grade, is an alternative that holds bonds from issuers like

Las Vegas Sands

(LVS) and Royal Caribbean. The fund’s performance has bested the two larger junk ETFs in recent years.

There’s a case to be made for active management in the junk market, where astute investors can add value. Closed-end junk funds offer higher yields than open-end funds and ETFs, thanks to leverage, which results in greater price volatility. “We believe there are great opportunities,” says Eric Boughton, co-manager of

Matisse Discounted Bond CEF Strategy
(MDFIX), which buys discounted closed-end bond funds in many sectors, including junk and municipals.

He says junk yields are attractive and closed-end funds are a cheap way to play the sector because the average fund discount to net asset value is 9%, versus 5% in the past two years.

The

BlackRock Corporate High Yield
fund (HYT), the largest junk closed-end fund at $1.2 billion, trades around $9 a share, a 9% discount to net asset value. It yields over 10%.

Nuveen Credit Strategies Income
(JQC), which buys leveraged loans, trades around $5, a 14% discount to NAV, while yielding 9.5%.

Leveraged junk closed-end funds have negative returns in the high teens this year, but if the market rallies, they could rise smartly.

Even individual bonds look attractive. Columbia’s DeYoung is partial to debt of

American Airlines Group

(AAL) and

Uber Technologies

(UBER). He favors a $3.5 billion issue from American backed by its AAdvantage program. Those 5.5% bonds due in 2026 now yield 8%. DeYoung says they’re safe, given the value of the mileage program and its importance to American. Uber, the big ride-sharing company, was profitable by one measure in the second quarter, which lifted its stock by over 30%. Its 4.5% bonds due in 2029 yield about 7%.

It’s not easy for retail investors to buy individual junk bonds, because many are issued as private placements under Rule 144A and available only to institutions (retail buyers can purchase some deals).

Barron’s has written about the high yields of “busted” convertible bonds, often issued by formerly popular growth companies, such as

Peloton Interactive

(PTON),

Wayfair

(W), and

MicroStrategy

(MSTR). These trade at steep discounts to their face value and carry yields to maturity of 10% or more. Peloton’s zero-coupon convertible due in 2026 trades for 67 cents on the dollar and yields 12%, while Wayfair’s 0.625% issue due in 2025 fetches 70 cents and yields more than 12%.

Bitcoin
owner MicroStrategy’s zero-coupon bond due in 2027 trades under 50 cents on the dollar and yields 18%. Most convertibles lack ratings and probably would be junk grade if they had them.

There is plenty to choose from now in the junk market.

Write to Andrew Bary at [email protected]