Near-record lows in yields are less painful when investors consider acceleration in two-decade trend
Many long-time investors in fixed income may see the near-record lows in junk bond yields and wonder if there’s any point left in holding them. And according to some who’ve been watching another trend, there is.
As reported by the Wall Street Journal, investment-grade companies have been trying since 2018 to lock in low borrowing costs for as long as possible as bond yields fall around the globe. The net effect has been an increased average time to maturity, even as the interest rates on their debt have declined slightly on average.
“[But] junk-rated bonds, unlike investment-grade bonds, typically can be redeemed, or called, before their maturity date—an option that companies are increasingly likely to take advantage of in order to replace older bonds with new, lower-coupon debt,” the Journal reported.
Reflecting these divergent trends, average durations in investment-grade bonds have generally been increasing, while those for speculative-grade bonds have been getting shorter. The trend has also intensified since the end of 2018: according to Bloomberg Barclays data, the average investment-grade bond duration has increased 13% to 8.02 years, while the average duration for junk bonds has dropped 24% to 3 years.
“All else being equal, longer-duration corporate bonds are riskier than shorter-duration bonds because there is more time for their value to be hurt either by rising interest rates or a downturn in a company’s financial performance,” the Journal noted.
As of Thursday, the Bloomberg Barclays U.S. high-yield index reflected a yield of 5.17%, compared to an all-time low of 4.83% in June 2014. On the other hand, constituents of the index also showed an average duration that’s a little more than a year shorter compared to five and a half years ago.
A recent Bank of America report noted that from a historical standpoint, the gap in yields between the bottom rung of investment-grade bonds and the topmost investment-grade bonds are narrow. But adjusting for changes in duration, the authors said, reveals a more marked disparity.
A succession of companies refinancing their debt has pushed up the average duration of investment-grade companies. That has bolstered the case for junk-bond investment, though some warn that a softening in demand for the debt could lead to a spike in durations, pushing yields higher and reducing the prospects of an early-redemption scenario.
“[M]ost speculative-grade bonds still are riskier than investment-grade bonds because there is a greater chance they could default,” the Journal said. “The question for investors is whether the lower-rated bonds offer enough yield to compensate them for that added risk, while also accounting for factors such as duration.”