Are junk bonds the new stocks?

New research suggests high-yield fixed-income securities can deliver outperformance for patient long-term investors

Are junk bonds the new stocks?

As the world finds itself stuck fast in the quicksand of zero interest rates, investors have been forced to extend their hunt for yield. For some, that has meant carving out a place for alternative investment strategies or assets. For others in fixed income, it’s been about spelunking into junk territory.

To be sure, there’s a lot of risk attached to accepting high-yield bond exposure in one’s portfolio. But new research suggests that hanging on to them for the long run can pay off handsomely.

In a piece published by the Wall Street Journal, Derek Horstmeyer of George Mason University’s Business School noted that while low-grade municipal and corporate debt can certainly do well in the long run, the way they react to market drops and panics makes them too volatile for many debt investors.

But by examining high-yield bond mutual fund performance over the past 30 years, he said, the disciplined junk-bond investor may get total returns approaching those of U.S. equities.

“Since 1990, the average high-yield debt fund has delivered an average annual return of 7.1% with a volatility of 7.7%,” he wrote in the Journal. “Compare this with the average short-term U.S.-bond fund, which delivered 3.8% with a much lower volatility of 1.5% over the same period.”

That return and volatility profile, he noted, is more reminiscent of equity than debt. Over the same 30-year stretch, the S&P 500 has offered an average annual return of 7.8%, but its volatility of 14.5% indicates a long and bumpy ride.

Deep plunges and stomach-lurching movements are the price fixed-income investors must pay if they want a great return from high-yield debt, Horstmeyer said. He pointed to the middle months of 1990, when high-yield fixed-income funds lost 13% of their value on average; August 1998 and June 2002, he added, saw the average high-yield fund lose 7% and 8% of its value, respectively. That’s to say nothing of the financial crisis of 2008-2009, when junk bond funds got annihilated to the tune of a 25% value loss over the whole of 2008, including a sheer drop of more than 15% just in October.

“In all, over the past 30 years, the average high-yield debt fund has dropped more than 2% in a given month on 31 occasions,” Horstmeyer said. Over that same timeframe, the average short U.S.-debt fund has lost at least 2% in a month just once: against the backdrop of the coronavirus-induced March madness this year, the average short-term U.S. debt fund shed 2%, in contrast to 11.6% for the average high-yield fund.

But in a piece of good news – or possibly bad news for those inclined to prefer predictability – declines in the high-yield market don’t always come during downturns in the U.S. equity space. Referring to the dot-com bubble burst, Horstmeyer noted that the slide in equity markets came with barely any movement in junk bond fund returns, which went on to finish 2000 with positive annual returns. For that calendar year, the S&P 500 was decimated, losing over 10%, while the Nasdaq saw 35% of its value destroyed.

“For the adventurous investor with a long investing time horizon, high-yield debt might be a good addition to the portfolio,” Horstmeyer said.


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