There's Value In High-Yield Bonds
The average high-yield bond fund has tumbled 24% over the past year — the worst showing among classes of fixed-income funds. So where is the appeal in funds that hold securities commonly referred to as “junk?” Aggressive investors now have an opportunity to exploit near-record yield spreads.
Over the past 25 years, junk bonds have typically offered yields four to five percentage points above Treasurys. But the spread hit 20% late last year and remains near historic levels. The Merrill Lynch U.S. High Yield Master Constrained Index yields 20.7%, versus 3.0% for the 10-year Treasury bond. Based on the Merrill Lynch High Yield 100 Index, which holds the 100 largest junk bonds, the spread is roughly 10%.
Of course there is a catch — default rates on corporate bonds have accelerated, sending bond prices sharply lower and yields skyrocketing. According to Moody’s, a total of 101 corporate bond issuers worldwide defaulted in 2008, up from just 18 in 2007.
U.S. companies accounted for nearly three-quarters of defaulters, with the bankruptcy of Lehman Brothers the largest in history.
2009 could be even worse, as Moody’s predicts that the default rate for bonds below investment grade will approach 15% — levels reported during the Great Depression. According to Moody’s, the number of corporate defaults will triple to about 300 this year.
Even with a tenuous backdrop, the high yields available on junk bonds appear to overcompensate investors for the risk of default. A back-of-the-napkin calculation shows that recent yield spreads exceed projected losses.
Since 1982, the recovery rate (the percentage of a debt’s par value that creditors collected after a default) has averaged 41.4%, putting the loss rate at 58.6%. Multiplying Moody’s projected default rate of 15% times the loss rate of 58.6% equals 8.8% — the “break-even” spread needed to offset projected losses. At 17%, the current spread between the yield of the High Yield Master Constrained Index and the Treasury bond is nearly double the 8.8% expected loss.
High-yield funds are aggressive investments. Still, lofty yields and the potential for a rally justify adding the funds to a diversified portfolio. Subscribers should consider Wells Fargo Advantage High Income ($6; STHYX) our top pick. The fund is taking the place of USAA High-Yield Opportunities ($5; USHYX) in our recommended Conservative and Growth Portfolios. Wells Fargo Advantage High Income, yielding 10.3%, tumbled 18.3% last year but is up 0.9% in 2009.