“Junk” bonds look very tempting right now…
The trailing-12-month yield for the iShares iBoxx High Yield Corporate Bond Fund (HYG) is about 4.8%. And HYG’s “30-day SEC yield” is around 7.8%.
The so-called “30-day SEC yield” is a standardized way of looking at bond returns…
The U.S. Securities and Exchange Commission introduced the metric in 1988. It tells us what the yield would be if the past month’s interest and dividends persisted for the next 12 months.
Well, we’ve now lived through near-zero yields for years. That makes a yield of nearly 8% pretty attractive.
And frankly, that type of return in this economy is outstanding. As we’ve discussed many times, the benchmark S&P 500 Index is down roughly 22% from its early January peak.
So I don’t blame you if your search for yield heads into the bond market. And it wouldn’t surprise me if you’ve considered junk-bond exchange-traded funds (“ETFs”) like HYG either.
But folks… investors call them junk bonds for good reason.
If you’re considering this move today, that means we’re due for a refresher. We need to go over the risks that junk bonds pose to investors…
They’re especially risky in a recessionary period like the one we’re facing. You don’t want to get caught chasing that nearly 8% yield without understanding why it’s at that level…
The following table compares HYG to the iShares iBoxx Investment Grade Corporate Bond Fund (LQD) and the Invesco BulletShares 2027 Corporate Bond Fund (BSCR). The latter is a specialty ETF whose holdings will all mature in 2027. Take a look…
At first glance, HYG looks like the best choice. This ETF offers a high yield today, as well as a relatively short duration.
But we need to go beyond the first glance. We can’t ignore credit risk.
You see, by definition, a junk bond is “below investment grade”…
That means credit-ratings agencies believe the issuing companies are at risk of default. In other words, junk bonds are issued by companies with a real risk of not making their debt payments.
So if you invest in ETFs like HYG, you’re adding huge credit risk (from potential bond defaults) to your portfolio. Ideally, the higher yield should offset credit-related losses. However, it doesn’t work that way in the real world…
If a company misses an interest payment, its bonds will suffer permanent damage.
These companies usually try to work with their creditors to “restructure” their debt. That means amending the original contract to give companies more lenient (affordable) terms.
The company often gets all (or at least most) of what it wants. Creditors will usually vote “yes” when management threatens to file for bankruptcy. They fear waiting years for a possibly worse outcome.
But in the end, whether through private negotiation or bankruptcy reorganization, creditors often wind up with much less than 50 cents on the dollar. A liquidation bankruptcy is the most extreme outcome. That often brings back next to nothing for the creditors.
And here’s the bottom line for investors right now…
Everything about today’s market environment is increasing risk for companies like the ones HYG holds. Think about it…
Even great companies can lose money during economic downturns.
So just imagine what will happen to companies that can barely make their credit payments. They’re already on the edge of the cliff… And they’re about to fall off.
Even without an official recession, HYG is a laggard. Don’t get caught up in whether the government says we’re in one or not. Things could always get worse.
Let me finish with one more reason to avoid HYG. The Power Gauge is “very bearish” on the ETF right now.
So it’s best to follow the junk-bond world as a spectator. Don’t fall into the yield trap.
They’re called junk for good reason.
Good investing,
Marc Gerstein
