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CANEY CREEK REPORT: High Yield Bonds - Not Exactly

| May 01, 2018
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The most overvalued asset type in the markets today is high yield bonds. These so-called “junk” bonds are generally rated below investment grade. That means the rating agencies like Moody’s and Standard & Poor’s feel that there is at least some risk that the individual issuers could default on their promise to repay the bond buyers. For that reason, most investors use widely diversified funds in this sector in order to mitigate the specific risk inherent in the individual issuers. There are high yield mutual funds, ETFs, and closed-end funds to choose from.

Historically, junk bonds have had returns of 5-6% over US Treasury bonds. That is quite similar to stocks. Over an entire economic cycle, high yield bond funds have suffered defaults of over 2% on average annually, which is why investors have demanded wide spreads over Treasuries to invest in the sector. The current cycle has been extended by the Federal Reserve’s zero interest rate policy. So defaults have been low. That policy now has been discarded. When the next economic slowdown arrives, junk bond spreads will explode.

Today, high yield bonds on average pay only 3.3% over US Treasuries of comparable maturities. As recently as early 2016, the high yield spread to Treasuries was 8%.

Today’s low spreads are not lost on issuers of junk bonds. According to Barron’s, fast growing, low rated issuers like We Work, Netflix, etc. that would ordinarily finance their growth through equity offerings of highly valued stock, are using junk debt as the demand for high yield is so great and the cost so cheap. Netflix just issued $1.9 billion of 10 year notes yielding 5.875%. That is less than 3% above 10 year Treasuries. Sellers know it is a great time to sell. Buyers beware!

In addition, as the Federal Reserve continues to raise rates this year, it becomes more difficult to justify taking the risk in low quality bonds. Money market funds now yield an average of 1.5%. Municipal money market funds now offer a tax equivalent yield of close to 2.25%. And, as the Fed is planning to raise overnight interest rates two to three times over the next eight months, these yields should rise another 0.5 to 1%. This is giving some competition to stocks, but it is serious competition to junk bonds.

As for stocks, they appear fairly valued. The current forward price/earnings multiple for the S&P 500 implies an earnings yield of over 6% plus a dividend yield of about 2%. So, a total return of about 8% is being forecast by the market. That is about “normal” compared to Treasuries today.

Stocks will also face competitive pressures as interest rates rise, but at least they don’t appear overvalued. It will be interesting to see if the so-called value stocks begin to perform better than growth stocks. Growth recently has outperformed for a long time in a low interest rate environment. Value has historically outperformed when rates rise.

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A note from WSC and WAMI . . .

Robert C. Davis is a Chartered Financial Analyst and is affiliated with Woodlands Asset Management, Inc. as a consultant.  Founding partner of Davis Hamilton Jackson and Associates, a Houston based investment advisory firm; Bob is now retired and living in Chappell Hill, Texas.  He now lends his expertise and knowledge of the markets to our company and customers.  We hope you find it interesting and insightful. 

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