Everything seems a little expensive lately, but are junk bonds the most overbought of all asset classes?
Junk bond yields fell this week, and prices moved up as investors piled into mutual funds and exchange-traded funds. Yields on bonds move inversely to price -- when bonds are going like hotcakes, prices go up as a result of demand, and yields go down.
The Wall Street Journal story, "Yields for 'junk' resume descent," makes the point that the improving economy is increasing investors' appetites for risk, which is pushing them into the high-yield area.
From the story:
Analysts said demand is rebounding on signs of an improving U.S. economy, which lifted the Dow Jones Industrial Average to another all-time high on Wednesday. Moreover, the number of companies defaulting on debt is low, and firms have amassed healthy levels of cash on their balance sheets, said LPL Financial strategist Anthony Valeri, meaning junk-rated companies are in a good position to pay back their debts.
In the story, reporter Patrick McGee writes that the high yields on junk bonds offer some protection to a rate increase, and that, "Yields on junk bonds don't move closely in step with Treasury bonds."
But here in the post-financial meltdown world, there may be more risk in high-yield bonds than some investors anticipate. "In the old days, junk traded versus the economy rather than interest rates. Now however, I think junk is vulnerable to a rise in rates. Oddly enough, it was often the case that in a rising-rate environment with a better economy, junk would increase in value. People perceived the companies as healthier in a good economic climate and would continue to buy the paper," says Donald Cummings, managing partner at Blue Haven Capital in Geneva, Ill.
The other side of the coin is that high-yield bonds tend to be highly correlated with equities in times of crisis, according to Jeffrey Nauta, CFA, CFP professional and principal at Henrickson Nauta, in Belmont, Mich.
There's the potential for danger on both sides. If the economy takes off, a raise in interest rates could catch investors unaware. At the same time, if the economy lapses back into bad-news mode, this sector of the bond market could stumble.
"If you stretch for yield, you’ll eventually get your hand slapped," Nauta says.
How do you use bonds in your portfolio -- are they for stability, income, or do you take a total return approach?
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Senior investing reporter Sheyna Steiner is a co-author of "Future Millionaires' Guidebook," an e-book written by Bankrate editors and reporters. It's available at all the major e-book retailers.