Are High-Yield Bonds a Wealth Equalizer or Investment Trap? (Answer Inside)

By TradeSmith Editorial Staff

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In November 2013, when I had to pull money from my little girl’s college fund to pay my mortgage, I hit a mental low point and realized I was in financial trouble.

I was a hard worker and had climbed every corporate ladder possible, but I was stuck living the Standard American Dream (SAD): I was saddled with debt, had poor credit, and never felt like I could get ahead.

Eventually, I started consuming everything I could about the world of personal finance, and a light bulb went off that made the vague concept of “debt” crystal clear. Debt is really just other people investing off of you. In exchange for receiving money, you pay the lender outrageous interest over time.

The person lending the money doesn’t care if you have to work overtime, get a second job, or drain your savings account to pay off the loan; they just want to sit back and collect checks.

Now, one way to turn the tables is through bonds.

With a bond, you loan money to a company or government entity, which sets terms for interest rate payments. The entity also sets the maturity date (when it will pay back your principal). Whoever you loan the money to is supposed to be working hard for you, and you’re supposed to be able to sit back and get paid.

Right now, there’s a contingent of analysts out there who say that junk bonds (riskier investments that offer higher returns) are historically cheap and offer incredible opportunity.

They point to inflation and declining stock prices as reasons to own this part of the market.

Yet I believe they are dead wrong.

High-yield debt may be cheap by historical standards, but it looks more like a trap right now than an opportunity. Let me explain my thesis so you can see how to navigate this sector.

A Bit of Background

Until the 1980s, the market for high-yield debt bonds didn’t really exist. These bonds only came into existence when an investment-grade company was downgraded.

It wasn’t until a major investment bank called Drexel Burnham, led by Michael Milken, began facilitating leveraged buyouts of companies that the high-yield debt market really took off.

Essentially, Milken would sell high-yield debt to finance leveraged buyouts.

During the 1980s, the junk bond market grew at an alarming rate of 34% per year, jumping from $10 billion to $189 billion by the end of the decade.

Borrowing rates for companies plunged as investment-grade corporations issued debt at cheaper rates, and the rates on junk bonds continued to drop as their popularity rose.

The frenzy came to an end with Drexel Burnham’s bankruptcy in the early ’90s. Yet the junk bond market quickly recovered, returning 15% annually from 1990 to 1999.

In the chart below, you can see how the rate for junk bonds trades over time.

Source: Federal Reserve

If those returns seem rich, it’s because they are.

Even today’s average rate of 8.39% is high compared to the average over the last two decades.

But you can also see that it gets to extremes during times of stress. And what many investors fail to realize is that these higher rates come with an increased risk of default.

The chart below from S&P Global tracks the default rate for speculative-grade (junk) bonds versus investment-grade bonds over the years.

Source: S&P Global

During the best years, default rates are down around 2% for junk bonds. But during stress periods, they jump as high as 10%.

Unlike stockholders, who can be left with nothing when a company defaults, bondholders can and often do get much of their principal back. More often, the terms are renegotiated to extend the life of the bond.

That’s fine, except that it takes much longer to get back the money you lent, effectively negating those enhanced returns.

While much of this may seem rudimentary to some of you, it’s important to put juicy yields into context. Otherwise, we can get caught up in our own greed and dismiss the real risks associated with these types of investments.

High-Yield Debt Today

The average retail investor has access to investing in high-yield debt through ETFs like SPDR Bloomberg High Yield Bond ETF (JNK).

Let’s look at the chart of the JNK.

Source: TradeSmith Finance

First, I want to point out some key technical items.

At the bottom, you’ll notice that the Health Indicator now sits firmly in the Red Zone.

Second, the current price of the JNK is still well below 2018 levels and now borders on prices we haven’t seen since the Great Recession.

Back then, the Fed was pumping money into the economy to keep rates down.

Now, it’s doing the exact opposite.

It’s still quite possible that we’re headed into a recession, which means business activity should drop.

On top of that, any company that issues new debt will do so at higher interest rates, costing the company more each year.

With so many companies borrowing to survive in 2020, many of them will likely be unable to pay off their debt or service it at higher interest rates than they currently do.

Now, you might be wondering why I wouldn’t see this as a buying opportunity, given the “cheap” price of JNK.

To answer that, I want to refer back to the two earlier charts showing high-yield debt interest rates and default rates.

We have yet to see either of those move to extreme levels that would warrant me wanting to step in front of the headwinds I just listed. If anything, I expect that high-yield debt markets will get worse before they improve.

In a recent TradeSmith Daily, I highlighted four stocks that carried enormous amounts of debt and burned through cash.

Any company that pays a high percentage of its revenues toward interest is going to have problems in the near future.

This is going to be particularly burdensome on smaller companies that don’t carry the same credit ratings as the large ones.

That’s a big reason I expect small caps and the iShares Russell 2000 ETF (IWM) to continue to struggle over the next several months.

And it’s why I’m focused on companies with solid balance sheets, great cash flow, and economic moats instead.

For more on moats and what Senior Analyst Mike Burnick and I have been pounding the table about, check out the stories below: