It’s something of an understatement to say that investors have struggled to generate yield since the financial crisis. The Federal Reserve has sat on rates in an effort to stimulate the economy, and, in the process, has pushed yield-famished investors into riskier and riskier asset classes such as junk bonds, utilities and real estate investment trusts. The problem is that investors are making so little on junk bond yields, for example, that when you take into account the historical loss rates, they’re not making much more than they would in US Treasuries.
One way to measure whether junk bonds are worthwhile or not is to look at a simple spread metric, or to see how much extra yield above a 10-year Treasury the junk bond index is yielding. The historical average spread is around 5.7% (see Figure 1). Right now, the spread is around 3.8%. That’s definitely below average, but it’s still enough to keep investors interested and invested in the asset class.
Don’t forget defaults
Here’s the problem with a simple spread analysis though: it doesn’t take defaults, recoveries and losses into consideration. Historically, junk bonds have defaulted at a rate of 4.2% annually, according to Standard & Poor’s. Investors have recovered around 40% of those defaults, making the annual loss rate (60% of the default rate) around 2.5%. When an investor undertakes this analysis, it can present a different picture and lead to a different investment thesis.
If we subtract 2.5 from 3.8 to determine the loss-adjusted spread, we get 1.3%. Of course, exposure to a junk bond index isn’t free. Funds such as the iShares High Yield Corporate Bond ETF and the SPDR Bloomberg Barclays High Yield Bond ETF charge expense ratios of 0.49% and 0.40% respectively. That takes the loss-adjusted spread down to less than 1% (see Figure 2).
In fact, when we look at the 30-day SEC yields of these two funds – instead of what the St. Louis Fed reports as the yield of the BofA Merrill Lynch US High Yield Master II index – we see that the iShares fund is paying 4.96% and the SPDR fund is paying 5.06%. If we subtract a 2.5% annual loss rate from those yields, the investor is left with around a 2.5% loss-adjusted return.
That means that if historical loss rates persist, an investor will make almost nothing over a 10-year Treasury for the trouble and risk of investing in corporate junk at current prices and yields. It’s true that loss rates could be better in this cycle than in the past. But most observers admit they don’t have a good reason to think so. Loss rates could also prove to be worse given how much borrowing has occurred since the financial crisis. The Fed has arguably constructed a post-crisis credit regime in which substandard companies have seemingly endless access to capital markets during a tepid recovery, creating so-called zombie companies. When the window to borrow closes, the spread widening could be as bad as it was in 2008.
All that junk
Defenders of junk bonds say defaults have been low lately, and that’s true. As one of my Twitter followers said, defaults are running at 2% currently (see Figure 3). But it isn’t really reasonable to extrapolate recent low default rates into the future. Defaults aren’t really ‘running’ at anything. They have been something over the past year or two, and they will be something in the future. And those two things might be quite different.
That’s because junk bonds have always had periods of low defaults. In fact, the history of the asset class shows long periods of calm, with hardly any defaults, and then periods where defaults explode. It’s true we don’t know when the next spike in defaults and widening of spreads will occur, but it is doubtful investors are getting paid enough to take the risks they are in the high yield sector.
All of this means that the two main junk bond ETFs and some of the largest actively-managed funds are offering meager potential loss-adjusted returns. The most egregious cases (see table) – where the loss-adjusted spread is actually negative – may be distorted by the fact that a fund’s portfolio skews to higher quality (BB-rated) high yield bonds. This is true for the Pimco fund, for example. That fund is delivering less yield than its peers, but it is also probably less exposed to the weakest credits.
Still, it’s clear that spreads are narrow and investors aren’t being compensated for risk as they have been at other times. This puts a premium on the talent of active managers to avoid defaults. And with so much money stuffed in these funds, the pressure is on these managers to get their allocation decisions right.