"Junk" Bonds Are Anything But
These bonds flourish way more than they falter and offer current yields of 4%.
There are two familiar labels for corporate debt with Standard & Poor's credit ratings weaker than triple-B: high-yield bonds and junk bonds. I submit both are obsolete, or at least misleading.
That is not to accuse Wall Street of doublespeak. Once upon a time, much of this debt was indeed speculative and illiquid. But my experience, and yours if you have invested in the category since the 2008 fiscal crisis, is that these bonds flourish way more than they falter.
That’s the story again in 2021: Below-BBB ratings upgrades outnumber downgrades this year by eight to one, including some promotions to investment grade. The unfortunate side effect of this "rising stars" theme is that current yields (what you get on new money) have dwindled. But with $18 trillion of bonds worldwide priced to pay less than zero, and Goldman Sachs advertising its 0.5% Marcus online savings account as "high yield," 4% is high enough.
I remain a fervent fan. You should too.
Rewarding Track Record
S&P's high-yield index has a compound annualized total return of 6.8% for the past 10 years (through Aug. 31) and a one-year return of 9.8%, compared with 5.0% and 2.8% for S&P's index of investment-grade bonds backed by companies in the S&P 500.
Yes, you are supposed to get extra return for taking on more risk of defaults and downgrades – and you truly do. Your target should be about 4% income with more capital gains than losses over any reasonable holding period, which allows for the occasional sell-off.
I am a booster of active bond-fund management and not of indexing. Fidelity Capital & Income (FAGIX), a longtime Kiplinger favorite, has a one-year return (through Sept. 10) of 21% and 8.5% annualized for 10 years.
If you think that Capital & Income's small sleeve of stocks distorts this comparison, I'll note that pure below-BBB bond-fund offerings from American Century, Hotchkis & Wiley, Manning & Napier, Northern Trust, Payden & Rygel, PGIM and USAA have made plenty of hay this year, and they've succeeded for a long time with portfolios centered largely on bonds rated B and BB with yields to maturity today between 3.5% and 5.5%.
Among closed-end funds, there's the amazing New America High Income (HYB), which is the T. Rowe Price High Yield fund in disguise. It has the same managers as T. Rowe's open-end flagship high-yield fund but a better long-term record, helped by the combination of mild leverage and frequent opportunities to buy shares well below net asset value. HYB has a one-year return of 23% on its share price and a fine 12% if you measure by net asset value. In 2016 and 2019, its shareholders earned more than 30%.
My research and recent conversations have me convinced this bounty is not over. "We are embarking on a huge upgrade cycle and at a record pace," PGIM bond strategist Michael Collins said in a recent webinar.
Barings chief market analyst and global strategist Christopher Smart told me that wealthy international clients remain hungry for high-yield U.S. assets, including corporate bonds, private lending pools, real estate financings and high-rate bank loans. When your hometown yields are negative, there is ample scope to absorb any wobbly trading spells in the high-yield market.
And the news trajectory is pointing up. There's serious talk that Ford Motor (F) will win back the investment-grade rating it lost in March 2020, when the world was ostensibly ending. To stay liquid, Ford issued bonds with coupons of 8.5% to 9.625%. Its 10-year 9.625% bonds due in 2030, still rated BB+, have soared in value by 40% and are still priced to yield nearly 4% to maturity. If the upgrade comes through, funds that pounced on this paper last year will earn another windfall.