Junk bonds are sending an ominous warning

Junk bonds refer to those corporate bonds that are rated below investment grade. Its formal name is high-yield bond because it has to pay much higher yields due to being more risky with higher risk of default. That’s why people also call them junk bonds. In the past 6 years, junk bonds have been chased by fixed income investors as they cannot find better interest income from anywhere else in the zero interest environment. As such, it has almost become the Wall Street darling, a rather hot investment product for years. People simply forget about the risk associated with it; actually the risk is huge, especially when the interest starts to rise. In the last 2 weeks, junk bond investors got the first sense of what kind of risk they are facing: due to the plunge of junk bond prices within days, they got stuck when they wanted to sell as not like stocks, bonds are typically more difficult to sell. The situation was so severe, several junk bond funds, started with the largest fund Third Avenue, got blowup and could meeting investors’ request to sell. But believe me, this is just the beginning and actually junk bonds are sending some very ominous warning that go well beyond just the junk bond investors. It impacts the whole financial world.

 

According to last week’s Wall Street Journal, “Junk bonds are headed for their first annual loss since the credit crisis…..US corporate high-yield bonds are down 2% this year…”. According to Barclays, junk bond annual losses are rare and actually in the past 2 decades, there have been only 4 other instances with such losses. Two of them were followed by the recessions with market crashes, one in early 2000s due to Internet bubble and the other in 2008 financial crisis. In addition, more evidence for concerns also comes from the junk-bond default rate. For this year, the junk bond default rate is still less than 3% but it is estimated to jump to nearly 5% or more next year. Be aware, a rising junk-bond default rate has even stronger correlation with economy and more often signal a recession when the rate reaches a high point. As a matter of fact, in the past 3 decades, the junk-bond default only went above 4% three times and each time it preceded a recession that followed: 1991, 2001, and 2009.

 

So what does that mean for us? Well, if the history is any guide, we may be at an early stage of an economy situation that may lead to a recession later. Of course, it does not mean anything imminent and does not mean the stock market will crash straight from here. Actually the stock market may continue to be doing fine for a while before the recession finally hits us. I think this may happen in the next 12-24 months. Just keep this in mind with the understanding that risks in the stock market become increasingly higher moving forward. Accumulation of a good chunk of cash may be a good idea and do not bet too aggressively for speculation. Rather, buying good quality stocks at good valuation will be much better for your wealth! From now no, you may want to pay more attention to what the junk bonds are doing and easiest way to do this is via HYG.