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Junk Bonds Look Tempting, But Don’t Be Fooled

Junk Bonds Look Tempting, But Don’t Be Fooled

Stocks are for growth. Bonds are for income. That’s how investing has worked for generations.

But there’s always been a big problem with it.

No matter how high interest rates are, bonds never seem to provide enough income. That’s especially true now, with year-over-year inflation running at over twice the return of the highest-yielding government bond. (A negative real return.)

So, about 40 years ago, some clever investors came up for a “solution” to this problem — junk bonds.

The average historical junk bond yield is 9%. That handily beats inflation now. (Although current junk bonds yield just 4% on average — the same as a short-term Treasury bond.)

Still, many investors reach for yield in junk bonds…

This is almost always a bad decision.

Today, I’ll show you precisely why an attractive-looking yield should never be the basis for an investment — and why options are a far better trade right now.

Who Junk Bonds Are Good For

Junk bonds became popular in the 1980s. They funded companies like Mattel, Holiday Inn, AMC Entertainment, and Barnes & Noble.

Even Occidental Petroleum, a Warren Buffett investment, needed junk bonds to stay in business when oil prices crashed.

Success stories like that attract attention from investors reaching for yield. But what these investors don’t understand is junk bond success stories tend to only benefit institutions with billions of dollars.

High yield or not, companies fail. Junk bonds in those companies default. Investors lose money.

In fact, issuers generally expect about 2% of junk bonds to default over 1 year, or 20% over 10 years. In recessions, defaults rise to more than 10% a year.

But defaults are a feature, not a bug, of junk bonds. The high yields in these bonds are designed to offset the losses. Over the long run, in theory anyway, junk bonds should beat high-grade bonds.

Because of this dynamic, junk bonds were intended to be a small part of a large portfolio that could withstand inevitable losses.

One of the key draws behind exchange-traded funds (ETFs) is that they promise diversified portfolios. They hold hundreds of securities. Losses in a few shouldn’t hurt investors too much.

That setup sounds perfect for junk bonds, where only about 20% are expected to fail.

Unfortunately, it’s not. One of the most dangerous tickers in the market right now is an ETF that’s loaded up with junk bonds.

Investors are reaching for yield in this ticker right now. And they’re going to get burned.

High Risk, Low Reward…

Junk bonds just aren’t a good fit for almost any individual looking for income. That’s because, contrary to their name, junk bonds are more like stocks than bonds.

Moves in the iShares iBoxx High Yield Corporate Bond ETF (HYG) are highly correlated with the SPDR S&P 500 ETF (SPY).

Asset correlations range from -1 to +1. Values above 0.7 indicate the two securities move in the same direction most of the time. The correlation between HYG and SPY is 0.77. This means HYG moves higher when stocks do and falls more when stocks fall.

But HYG still manages to underperform stocks in bull markets. The ETF gained about 30% from the March 2020 bottom. SPY gained more than 110%.

HYG also underperforms other, safer company bonds. In the 2020 bear market, corporate bonds lost almost 12%. HYG dropped almost 24%.

The chart below shows rolling 10-year returns for HYG and the iShares Core U.S. Aggregate Bond ETF (AGG). AGG holds high-quality corporate bonds. HYG delivered losses most of the time. AGG usually made money for investors.

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Heading into recession, you might be tempted to reach for yield. You might even want to add bonds with a high yield payout because they sound safe.

HYG’s 4.8% yield is tempting, but don’t fall for it. The ETF could lose that much in a week. That destroys the year’s worth of income you were promised when you bought it.

That doesn’t mean HYG can’t be traded. On the contrary, HYG’s dynamic of moving faster than the market in either direction makes it a great candidate for short-term options trading. But junk bonds aren’t safe enough for a buy-and-hold strategy.

Don’t reach for yield — especially in a recession. You’re likely to get burned.

Regards,Michael Carr signatureMichael Carr, CMT, CFTeEditor, True Options Masters

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