Yahoo Finanzen Why Fund Investors Are Dumping Junk Debt
Junk bonds took a little tumble recently. Should investors be worried?
There's no immediate cause for concern, but longer term a lot rests on how the oil market performs.
Here's the skinny:
Jitters. Even before the election, bond investors had the jitters.
In the three weeks through Nov. 11, the SPDR Bloomberg Barclays High Yield Bond exchange-traded fund (ticker: JNK), which tracks a basket of bonds of less than stellar credit quality, dipped 4.5 percent, while the Standard & Poor's 500 index rallied close to 1 percent over the same period. The fund has annual expenses of 0.4 percent or $40 per $10,000 invested.
That recent price drop might not sound huge, but in the context of the junk, or non-investment grade bond market, it is meaningful. The average annual return of the SPDR High Yield ETF was 5.42 percent over the five years through Nov. 18, according to Morningstar.
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So, the recent drop eliminated most of the average gains you'd expect from the fund.
Profit taking. The first part of the story is that gains earlier in the year were way above average.
"Primarily, it's some profit taking," says Dave Mazza, head of ETF and mutual fund research at State Street Global Advisors.
Through October, the fund returned more than 12 percent and that included the period of pullback. The idea that investors might lock in some profits makes sense.
If you were savvy enough to buy at the market lows during the first few weeks of the year, then the gains would have been even bigger.
Treasury market action. Another part of the equation is what's happening in the market for government securities.
"The drop in high-yield bonds has more to do with higher interest rates and virtually nothing to do with credit worthiness," says Jack Ablin, chief investment officer at BMO Private Bank in Chicago.
More specifically, the cost for the government to borrow money has risen a lot. The yield on the benchmark 10-year Treasury bond climbed to 2.31 percent recently, up from 1.82 percent at the beginning of November.
That of course means that all other borrowers pay even more. U.S. Treasuries are considered to have zero risk of defaulting on a loan because the government can always print more money or raise taxes in order to cover the cost of paying the debt.
As government bond yields climbed, so did junk bond yields. Given that prices move down when yields rise, the drop in high-yield prices isn't that surprising.
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"Fundamentally, credit conditions remain solid," Ablin says. The recent drop in high-yield bond prices has little to do with worries that the junk bond market is somehow closer to defaulting than it was a few weeks ago.
That sums up the current situation, but smart investors are already looking ahead to what might happen.
Future worries. "Treasuries seem quite risky here, and there is likelihood that rates will rise," says Henry Peabody, portfolio manager of the Eaton Vance Multisector Income fund ( EVBAX) in Boston. The fund has annual expenses of 0.95 percent, or $95 per $10,000 invested.
At least some of the risk involved with the U.S. government bond market is that inflation will rise and as a result investors will demand more interest. The higher rate on the government market then would kick through into the junk market. That's normal and perhaps a sign of an improving economy.
The importance of oil. There is another concern that revolves around a sector that has borrowed heavily and is now suffering: the oil business.
Oil companies with junk-rated debt have a problem. When the debt comes due it will need to be refinanced, likely at a higher interest rate than before.
The problem is that interest rates seem to be rising faster than oil prices. Light sweet crude prices have mostly traded in a sideways range between $40 and $50 a barrel since early April.
"This whole sector has interest costs rising and the prices of what they produce is not rising," says Don Coxe, CEO of Coxe Advisors in Chicago.
If the price of crude doesn't rally by the time the bonds get refinanced, then the credit quality for the specific bonds will fall.
Worse still, if enough of these junk-rated oil companies have the same problem then the entire junk debt sector could lose its shine to investors.
When to sigh with relief. "If oil breaks through $55 then I think you could have a good sector of the market to be in," Coxe says.
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What could make that happen? Strong economic growth across the globe, which would increase demand, and a weaker U.S. dollar. Oil is priced in dollars, so when the currency depreciates oil prices tend to rise.
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