If you think the stock market has bounced nicely, the junk bond rebound has displayed just as much vigor.
From its recent low on February 11 through July 12, the Bank of America Merrill Lynch U.S. High Yield Total Return Index is up a blistering 18%. Unfortunately the margin of safety in junk bonds may have disappeared for now.
A good way to think about junk bonds and the risk premium they may offer is to start with the spread, or difference in yield, between them and Treasurys, a putatively safe investment.
But just because junk bonds are yielding more than Treasurys doesn’t mean you’ll pocket that entire spread. Junk bonds are called “junk” for a reason — some of them default. So you have to adjust the spread with an estimated annual loss rate to arrive at the junk bond risk premium.
Here’s how the loss rate works, according to an excellent paper from financial adviser William Bernstein. First, not all defaults result in a total loss; there are recoveries. Historically, the recovery rate for junk bonds has been around 40%. The loss rate is simply the default rate multiplied by 1.0 minus the recovery rate.
To use Bernstein’s example, if the annual default rate is 7%, multiply that by 1.0 minus 0.40 (or 0.60) to arrive at an annual portfolio loss rate of 4.2%.
Finally, to arrive at the junk bond risk premium take the 4.2% annual loss rate and subtract it from the spread. If the spread or yield above Treasurys is greater than 4.2, there is some premium or reward for owning junk bonds. If it’s lower, there isn’t.
Now, it turns out that the historical default rate from 1985 through 2010 is more like 4.2% rather than 7%, but there are arguments that the current lending cycle has been worse than past cycles. Additionally recovery rates may be lower than the historical 40% this time around.
Everyone has to arrive at their own estimates of these numbers, but let’s be conservative and say the default rate should run 7% annually and the recovery rate will be 30%. That means the estimated annual loss rate is 4.9% — 7.0 multiplied by 1.0 minus 0.30 (or 0.70).
Some might call this example draconian, but recent estimates show that junk bond defaults are expected to approach 6% by the end of this year. Junk bond issuance has topped $1.5 trillion since 2010, making this the most prolific period in history. Moreover, anywhere from 15% to 20% of the junk bond market is in the energy sector, and defaults could combine with low recovery rates in that sector if oil stays below $50 per barrel.
Defaults are cyclical. Sometimes they are almost non-existent, and sometimes they spike to frightening levels. Advisers shepherding a retiree’s capital have reason to doubt that this cycle will be like the previous ones. With interest rates so low for so long, baking in a more painful outcome may be warranted.
So using conservative estimates, the spread had better be greater than 4.9% for there to be a junk bond risk premium or for anyone to consider owning a portfolio of junk bonds.
As it happens, the spread is 5.6% currently. That’s more than our estimated 4.9% loss rate — but not by much. The massive appreciation that junk bonds have had since February has sucked much of the premium out of the asset class.
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It’s better to buy junk when spreads have widened, not only because of the risk premium increase, but because there is an opportunity for spreads to narrow again. That potentially gives an investor both a hefty yield and some price appreciation.
Now, by contrast, prices have run up a lot and spreads have tightened. It’s unclear how much more they can tighten, especially if Treasury yields can’t decline much more.
The upshot is keep junk bonds to a minimum in your portfolio now. If you missed the opportunity in February, brush up on your risk premium formula and get ready for the next pitch the market throws. But, right now, junk bonds are all risk and no premium.