Get out of Junk Bonds

In the extremely low interest world, people are simply hungry of looking for high yield assets. Junk bonds are one of them. There is a reason why they are called junk bonds because the companies issuing such bonds are of noninvestment-grade and are at increased risk of default due to questionable prospects. As such, they need to offer higher yield to attract bond investor for financing. Logically if one can get a comparable yield from a much safer asset, they will much less interested to go with such risky bonds, unless the spread (difference) is substantially large to justify the risk. One common gauge used in the bond investment is the spread between yield on high-yield bonds and the yield on similar-duration government bonds. When the spread is large, it means junk bonds are paying much more than the safer government bonds. Historically, the spread should be at least 6% or higher for junk bond investors to carry a reasonable safety. But this is not the case today. Actually now is an extremely dangerous time to buy or hold junk bonds. Let me explain.
For almost a decade, the government bond yields have steadily gone down to the low level never seen before. The 10 year Treasury yield hit < 1.5% last year and even it has recovered a lot since then, it is still yielding below 2.5% as I’m writing. While the general trend for Treasury yield is going up in the years ahead, it is just not possible for it to go up very quickly given the current fragile US economy as a whole. In other words, people relying on fixed income don’t get enough money for their return and they are forced to go for higher income with more risky assets. That’s why junk bonds have been chased up for years. The iShares iBoxx High Yield Corporate Bond Fund (HYG) is up over 15% from its bottom in Feb 2016. This is a lot considering bonds typically don’t move up much. But the hungry fixed income investors don’t care about risk anymore as they simply need to find more income these days. When bond prices go up, its yield goes down as they are inversely related. Now junk bonds yield only about 6% now. With the government bonds yield about 2%, the spread is only 4% at the moment. It may not sound alarming but if you look at its historical data, this is in an extremely dangerous zone. We have only seen 2 times in the past decade when the spread was so narrow. One was in mid 2007 just before the Great Recession and you could certainly guess what had followed: a massive 30%+ plunge in the high yield bonds. Then we saw a similar situation again in 2014, which was followed by a 20% decline of junk bonds within the next 2 years. Of course I cannot tell the exact time point when the crash for junk bonds will come but if the history is any indicator, I’m pretty sure it is coming. I won’t be surprised to see another 20-30% plunge for junk bonds that may come any time soon! Let’s wait to see when and how the firework will play out in the months ahead.