The Case For High-Yield Bonds

As we all know, stock valuations reflect the prevailing economic weather and corporate-profit forecast. Sunny conditions give investors confidence to buy, which generally means expensive stock prices. Right now, the S&P 500 is trading at 17.0 times expected earnings, almost 20% above the 10-year average of 14.3. Some highfliers have ascended to nosebleed levels, notably names like Netflix (Nasdaq: NFLX) with a price-earnings (P/E) ratio of just above 245.

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While everybody loves rising markets, it’s hard to buy low and sell high when everything is already high.

#-ad_banner-#Fortunately, the reverse is also true. Logic dictates that your investment dollars stretch further (you can buy more shares) when economic rain clouds start to appear. This is usually when most investors duck indoors. But Warren Buffett has some great advice for these situations: Be greedy when others are fearful.

Just a few months ago, the market was pretty terrified of high-yield bonds. There was a rout underway in the telecommunications sector, and investors were worried that it could be contagious and spread quickly. In October, the sector suffered its sharpest monthly decline in nearly five years. And in one week in mid-February, fund investors withdrew $6.3 billion from this group — the second-largest exodus on record.

But just as quickly as it began, the panic suddenly ended. High-yield bond prices have begun to rebound, and the outlook hasn’t looked this bright in years.

There are still healthy 6% yields to be had — but they won’t remain for long.

Pretty Good Times
These are pretty good times for companies needing to borrow money. Wireless phone carrier T-Mobile (Nasdaq: TMUS) recently issued some corporate bonds for refinancing purposes. Proceeds from the new notes yielding between 4.5% and 4.75% were used to redeem older ones paying 6.8%, thereby saving the company millions in annual interest.

Nothing unusual there — T-Mobile is one of many companies enjoying cheaper funding. And they are taking full advantage by tapping the capital markets and using the cash to retire old debt and/or invest back in the business.

What’s out of the ordinary is the insatiable appetite from investors. In this case, T-Mobile was seeking to raise $2.5 billion in fresh capital, but underwriters were swamped with orders totaling $10 billion.

In other words, the issue was “oversubscribed” four times over.

Just a few weeks later, electric car maker Tesla (Nasdaq: TSLA) sold some bonds backed by consumer auto leases. Let’s just say there were plenty of eager buyers standing in line. For some of the notes, investors tried to purchase 14 times what the company put out for sale.

Neither of these companies has a stellar credit rating. They are both a few rungs below investment-grade on the credit-quality ladder. Normally, that scares away many people. But it doesn’t seem to be much of a deterrent right now — in fact, investors can’t get enough.

We’ll get into the reasons shortly.

The most creditworthy borrowers such as Microsoft (Nasdaq: MSFT) are given gold-plated ‘AAA’ ratings. These companies have pristine balance sheets, ample cash and liquidity, and “extremely strong capacity” to meet financial commitments. They once numbered in the hundreds, but only a few remain today. Companies that just miss this threshold are assigned ‘AA’ status.

Just as individual homeowners with higher FICO scores are able to lock in lower mortgage rates, these rock-solid companies are able to borrow cheaply. That’s because lenders are almost assured of getting their principal and interest paid in a timely manner.

So why would anyone lend money to weaker companies with a few blemishes on the balance sheet? Well, investors must be properly incentivized. The shakier the borrower, the more it must sweeten the deal with higher rates.

Would an extra 100 basis points (one full percentage point) over comparable U.S. Treasury bonds be enough? Probably not. Would 200 basis points do the trick? Closer, but still no. How about 365 basis points?

Now you’re talking.

That’s about where the spread between Treasuries and high-yield bonds stands right now. During times of economic duress and market uncertainty, this spread can widen dramatically to 1,000 basis points or more. (Remember, bond yields and prices move inversely. So when yields soar, it’s because prices are falling.)

But right now, we’re seeing the opposite. High-yield bond prices continue to rally, causing the spread to narrow. In relative terms, 365 basis points is tight — less than half the 800-point chasm from 2016.

But that’s because the fundamentals haven’t been this strong in over a decade. And it’s still a pretty wide gap. On a $100,000 investment, these lower-rated bonds will generate an extra $3,650 in annual income — or $18,250 over the next five years — above what Uncle Sam will pay.

In the simplest terms, yield spreads are influenced by market expectations of companies’ ability to repay their debts. A strengthening global economy is certainly supportive of these expectations.

Recent tax reform (which lowered corporate tax rates to 21% from 35%) is also a positive, as it leaves more cash to service debt. While changing provisions for interest deductibility and tax-loss carryforwards could actually hurt some borrowers, the overall net impact will be a decrease in bond issuance, an increase in nominal yields, and a likely compression of yield spreads.

Right now, only a handful of borrowers are having trouble making ends meet. Ratings agency Moody’s reports that default rates for speculative-grade debt have fallen below 3% for the first time in several years. That’s a benign level (and even in the rare event of default, a sizeable portion of the debt is usually recovered).

Perhaps Barron’s said it best: “Junk bonds aren’t very junky these days.”

Of course, smart investors are less concerned with where the market is at today and more interested in where it’s headed tomorrow.

Good news there, too: Moody’s is projecting that default rates will continue to fall toward historically low levels of 2.2% by the middle of 2018 and 1.8% by year’s end. For context, that’s less than half the 30-year average of 4.3%.

And it gets better.

This $1.3 trillion asset class is also less vulnerable to rising rates than other fixed-income groups. Investment-grade corporate and Treasury bonds rise and fall with changes in interest rates. By contrast, junk bond prices are credit-sensitive, not rate-sensitive. So like equities, their prices are more governed by what’s happening with the economy than Fed policy.

Since 1986, the benchmark Merrill Lynch High-Yield Index has outrun the Barclay’s Aggregate Bond Index in four of the past five rate-tightening cycles.
No wonder buyers have been so enthusiastic.

Don’t let the term “junk” scare you. True, these issuers are less able to withstand severe economic slumps. But we’re talking about solidly profitable companies such as Sprint, Dell, Safeway, and Rite Aid. And while spreads are thinner than in previous years, the best way to measure yields is in relation to defaults — which are headed to the lowest levels since 2008.

Furthermore, credit quality continues to improve. According to Fitch, high-yield credit ratings upgrades outnumbered downgrades last quarter for the first time in over a decade. Every upgrade usually means capital appreciation for investors — on top of the hefty interest payments.

Now, everything I’ve said up to this point refers to the high-yield market as a whole. But one small subset has even better credit quality, higher capital appreciation potential, and superior risk-adjusted returns. But I’m saving my analysis for this corner of the bond market for my premium High-Yield Investing subscribers.

It’s only fair. After all, my subscribers and I have been able to find yields of 6%, 7%, and even 10% or more — despite interest rates being near historic lows. So if you’d like to learn more about which areas of the bond market (and stocks, MLPs, REITs, and more) I like best for high-yield income in this market, I invite you to learn more about High-Yield Investing at this link.