Junk Bonds Becoming True To Their Name
Date Published: 15 August 2017
At SCM Direct, we are not complacent and are diligent in terms of constantly evaluating our asset allocation. One area of hot debate in our office at present is emerging market debt, with investors withdrawing $680 million from the iShares JPMorgan USD Emerging Markets Bond ETF last month; the biggest-ever flows reversal. As the chart below shows, there has historically been a link between fund flows into an asset (the blue bars show flows into the iShares JP Morgan USD EM Bond ETF) and performance (shown in red line):
Source: Bloomberg LP
Following an 18-month rally, investors fear that rising yields in developed markets could lead to a collapse in emerging market bonds similar to the 2013 taper tantrum when local EM currencies fell 14% and local bonds fell 7.3%. The opposite view is that faster growth in emerging markets and narrower current-account deficits support developing-nation bonds even after the increase in U.S. and European rates over the past year.
However, when one compares the premium over US Treasuries of EM Debt (shown in red) and US High Yield (shown in blue), it would appear that the real bubble is in high yield. The EM debt premium has been relatively stable, it is the high yield that has seen a dramatic fall in yield, particularly since the early 2016 collapse in confidence associated with low oil prices that led to a surge in defaults by high yield energy bonds. Personally, I find it astonishing that the yield on high risk, illiquid, corporate debt should be anywhere close to the yield of an Emerging Market Government bond.
Source: Bloomberg LP
We are not anti-high yield, we simply look at the fundamentals and evaluate their true value. We bought high yield back in February 2016 after high yield had been hit by worries of a US growth slowdown, renminbi devaluation, emerging markets and the fall in oil prices. At the time, you were being paid for the additional risk, with yields being as high as 8% pa above US Treasuries at the peak.
In March 2017, we sold our entire high yield as we believed the risk premium no longer offered enough value with yield premiums c3.9% at the time.
Interestingly, last week it was reported that US junk-rated corporate bonds have suffered their biggest two-day losses in nine months, sending risk premiums on the asset class to the highest level since April.
You might think that this should not worry most UK investors as they do not hold a junk bond fund but then many UK retail fixed income funds have significant exposure to junk bonds. A common definition of junk bonds is fixed-income instruments that carry a credit rating of BB or lower by Standard & Poor’s.
Using this categorisation and latest Morningstar data reveals that the average percentage invested in junk bonds within a sample of 67 funds analysed, was 29%. Many popular large funds within this sector have significant exposures to high yield – for example, one of the largest funds in the sector had 60.7% of its portfolio in high yield or unrated bonds at the end of June 2017.
Investors thinking they have low-risk investments just because they are fixed income funds should think again. Junk bonds fell by more than 30% after the Lehman Brothers collapse.