High-yield bonds are called “junk” for good reason…
They suffer from huge credit risk. That’s a big problem in a market environment like the one we’re in right now. And folks who don’t yet realize it will likely learn this lesson soon.
After all… Mr. Recession is a great teacher.
But junk bonds have another major problem as well…
As we’ll see today, it’s one area in which shareholders hold an advantage. And in the end, it’s yet another reason why folks like you and I should steer clear of these types of bonds…
First, we need to realize that bonds are much more illiquid than stocks. They can go weeks, months, or even years without trading.
That doesn’t mean the bond market is flawed…
Pension funds and insurance companies hold many corporate bonds. And many of these institutions don’t care about outperforming any benchmarks.
They simply hold the bonds until maturity rather than trade them. Their top priority is aligning expected cash inflows (from interest payments and the principal repayment at maturity) with anticipated spending obligations (such as pension benefits).
But that lack of liquidity leads to a lurking problem. It reveals a critical difference between stocks and bonds. And understanding this difference is key in today’s recessionary world.
To see what I mean, let’s compare junk bonds with distressed stocks…
Video-streaming giant Netflix (NFLX) plunged 35% on April 20, 2022. Investors reacted to terrible news from the company about its membership and revenue prospects.
Imagine if something like that were to happen to a junk-bond fund in which you invest…
The borrower announces that business is weakening. You look at your brokerage account as soon as you hear the news. And you see that the “reported” value of the bond is down 35%.
It might seem like Netflix’s shareholders and the holders of this now-distressed junk bond are in the same boat…
Both parties need to lick their wounds as they digest the price declines. And both need to get to work to figure out what to do next. Do they sell, hold, or perhaps even buy more?
This is where the key difference between stocks and bonds comes in. In short…
Netflix’s shareholders have the luxury of knowing the price of the stock at all times.
Type “NFLX” into any online search box. Within seconds, you’ll see the stock’s current market price. We know it’s right because many NFLX shares changed hands at that price.
Junk-bond holders can’t do that…
Remember, bonds are illiquid. So their prices can swing wildly and quickly. And to make matters worse, the prices that junk-bond holders see on daily reports aren’t always “real”…
By that, I mean they don’t come from the market itself. Rather, they come from pricing services hired by market makers like brokerages and hedge funds.
Since these services can’t see prices in the marketplace like with stocks, they estimate…
They use a lot of complex math to do that. Their goal is to capture the normal statistical relationships between more-liquid benchmark bonds (like U.S. Treasurys) and bonds of varying interest coupons, maturity dates, and other factors.
But when the market fears higher default rates, mathematical normalcy goes out the window. In times of crisis, bidders don’t care what the pricing-service algorithms say.
To put a point on it… Junk-bond holders don’t know the true prices of those assets.
If a company starts running into problems, a bond once priced in the $800 range could stop trading for a long time. It might resume trading at some point… but possibly below $200.
Pricing services won’t likely keep the junk bond’s value at $800 for long. But until a trade happens, nobody can truly evaluate whatever interim answer a pricing service delivers.
This isn’t a major problem with investment-grade bonds because crises are rare for these companies. Even if a bond’s price falls, the default risk is much lower with these businesses.
We can even live with junk-bond pricing-service algorithms when the economy is humming along. You don’t need to fret about the hard questions if bondholders don’t really need to ask them in the first place.
But we’re now entering a period in which investors will have to ask harder questions…
And as the threat of recession looms, we have no way of knowing whether we can trust the answers – until a trade occurs. By then, it could be far too late to rescue your portfolio.
So for now, my advice is simple…
Take care of your money. Don’t dabble in junk bonds amid today’s economic uncertainty.
Good investing,
Marc Gerstein
