A 5% Junk Bond Bubble: What Could Possibly Go Wrong?

In rare situations, it actually is better to sell off the stock of companies you own rather than try and live off the income. For those of you who pay attention to market history, you know that we are living in one of the worst times of high-yield American bonds with junk status that we have ever witnessed.

Right now, the junk bond yield of something like the Bank of America Merrill Lynch Index is at 5.002%. For a quick refresher on the topic: last year, the yields of junk bond indices fell below 5% for the first time in American history, and we are flirting with that mark again this year. My guess is that a lot of investors are saying, “A diversified basket of so-so securities yielding 5%, I’ll take it.” But you don’t want to put yourself in the position where you are buying something at such a lofty valuation that it has only been seen once before (and that was the previous year, which is still a part of this same business cycle).

Usually, each percentage point increase in interest rates causes the price of a high-yield bond fund to fall four to five percentage points. The history is a little messier than that, but it’s a useful back-of-the-envelope calculation to get a vision for what would happen if interest rates were to rise. But another way, if interest rates sharply increased by three percentage points, then high-yield bonds could decline by up to 15%, meaning it would take three years of collecting income from your fund just to break even in June 2017. And, of course, these securities use “high-yield” as a euphemism for bonds of companies that are so junky that they are not even investment-grade, so if you have a two-year deep recession hit, then you would see lots of defaults from the bond-payers in the index and your income might take an overall hit that way. Buying junk bonds today at a 5% is not incorporating Benjamin Graham’s margin of safety; in short, you’re betting on things staying roughly as they are today over the next few years so that you can get a total 5% return.

If I had to choose, I’d rather play market-timing than purchase junk bonds at these prices. At least with Visa, you have a company growing profits at north of 10% annually. Each profit increase would then place an informal lid on the valuation that the stock would see thereafter, and I’d rather count on Mr. Market to approximate Visa’s earnings per share growth than deal with a junk bond situation where a rate increase could easily cause a few years of income to disappear. This isn’t like dividend growth investing where you have companies raising their payouts every year to offset inflation; the bonds in the portfolio of an index generally make fixed payments.

If someone absolutely insisted on it, the best way to mitigate the damages would be to dollar-cost-average into something like the Vanguard High-Yield Corporate Fund Investor Shares (VWEHX). The yield there is about 5.5%, you get your dividends monthly, the expense ratio is only 0.23%, and if it were something that were part of a twenty-year investment plan that called for you to add, say, $300 monthly and automatically reinvest for long periods of time, you could probably get satisfactory returns out of it. You’d be relying on the minimal expenses, reinvest and payout monthly, and the fact that the dollar-cost-averaging in future years would diminish the negative effects of investing into the fund in 2014 to offset the nearly bubblicious valuations in the sector as a whole.

If you’re itching to make an investment, and nothing looks all that appealing, the best thing to do is find something with a high earnings per share growth rate. That’s why I talk about Visa and Becton Dickinson here. A lofty valuation can be defeated with high growth. With junk bonds, the payment is what it is. When the valuations get lofty, your only hope is that (1) there is no deep recession imminent, and (2) any rate increase is slow and gradual, this minimizing the potential effects of the excessive valuation. When income is offered to you on bad terms, find a place with high earnings per share growth instead. They can at least “grow out it” when it comes to the valuation problem.