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Wednesday, August 15, 2012

Junk Bond Facts

One of my favorite financial writers, a man with a sharp wit and ability to simplify complex investment topics, is John Waggoner at USA Today. Recently, he wrote a column Are junk bonds trash or treasure these days that is loaded with facts useful for the DIY investor. Junk bonds, or as they are more politely called, high yield bonds, represent at least a small portion of most DIY investors' portfolios via exchange traded funds like HYG or JNK.

Here are some of the facts that I garnered from the article:

  • junk bonds yield between 7% and 8% versus 1.62% on the 10-year Treasury note (actually the 10-year T yield has since moved up to 1.80%)
  • over the past 15 years, the average junk bond fund has gained 5.18%/year versus 4.72% for average large blend stock funds (think S&P 500 comprised of value stocks and growth stocks)
  • high rated corporate bond funds gained an average of 5.77% over past 15 years
  • long-term government bond funds have trounced junk and corporate bond funds, up an average of 9%/year
  • worst 12 months for junk bond funds ended 11/2008, when average junk fund was down -30.1%
  • other 12-month losses were 2000-2002 bear market and 1990 - 1991 recession
  • today, according to Moody's, junk bonds yield an average +6.83% to Treasuries and the average yield spread is +5.61%
  • more companies had ratings upgraded than downgraded in the 1st quarter
  • current default rate = 3.1% versus 1.9% in December
  • Moody's estimates the default rate will peak at 4% in October and fall to 3% in May
  • Worst case is greater than 10% default rate in 5/2013.


The first obvious take-away is that Waggoner's articles are flush with useful information.  Secondly, junk bonds are fairly attractive on a yield spread basis and on an expected default rate basis. Other things equal, a yield spread of +6.83% overcomes 4% default rate. Thirdly, this sector gets pounded in an economic downturn. Thus, if you are expecting the economy to weaken, lessen exposure. If the yield spread to Treasuries gets to less than +5.61%, again think of lightening up a bit - this is the point where you start to not being paid to take the risk. A final point to note is that, when investors get scared, nothing beats Treasuries, as shown by the performance numbers Waggoner reports.

I suggest that DIY investors interested in following markets read Waggoner's column. You may also want to check out his book Bailout.


  1. Yield spread is a yardstick I use to determine if junk is overvalued or undervalued. Junk is called junk for a reason, and much of investment success is managing risk.

    1. I agree...spread is the determining factor. This is one area where reversion to the mean systematically occurs. It does take discipline however to buy when spreads are wide, i.e. times are scary.
      It interests me that yield spread data is not freely available. I construct my own off of Yahoo bond yields.

  2. Is there a risk that folks are reaching for yield again. With my compatriots in the UK, there is a desperate search for yield. Of course, it was the search for yield that started the whole mess. Investors around the world thought that US sub-prime bonds were a guaranteed win, but everyone knows how that turned out.

    1. People are definitely reaching for yield. The Federal Reserve has forced people to take on risk and they don't know the risk they are taking. A sharp rise in rates will cause a blood bath. Baby boomers have seen their house values drop and risk free yields plunge.

  3. This is a amazing fact about closed end high yield bond funds. Back in 2008 and 2009 during the financial panic high yield closed end bond funds were yielding over twenty percent. Everyone was expecting a nineteen thirities style depression. That did not happen what did happen is those closed end bond funds increased in value by two or three fold in about three years thats even after you took out all your dividend distributions in cash.