Junk bonds—high-yield debt from riskier companies that are rated below BB by Standard & Poor’s—could provide a solid source of dividend yield and capital appreciation, and investors should consider holding them in their portfolios, contends an article in MarketWatch.
With rising concerns over a recession, many believe that defaults are going to be high, but that isn’t necessarily true, Kevin Loome of T. Rowe Price told MarketWatch, adding that “now is a very attractive time to enter the asset class.” The BB rating is generally where junk or speculative-grade status starts, just below the lowest investment-grade range at BBB. AAA is of course at the top, while C and D are all the way at the bottom, and the riskiest. The current junk bond dividend yield is 8l7% overall, but there’s potential for a much higher return if their prices go up, which is likely.
The article lays out 5 reasons why investors should consider adding junk bonds to their portfolios:
- Junk bonds have been battered this year, and the only other instance in recent history when they were down more than 2022 was in 2008, when they plummeted 26%. But they shot back up 55% in 2009. So while the initial drop was painful, investors who hung onto them had a positive outcome.
- While junk bond prices could plunge more in a deep recession, most strategists—like Loome—believe the recession will be shallow. Loome puts the corporate bond default rate at 4%, and Bank of America estimated 3.4% in a recent note, according to the article.
- There are signs that inflation is starting to ease: prices are down for cars and durable goods as well as commodities such as oil, copper and lumber, and 10-year Treasury yields have dropped. But according to Bank of America, inflation can sometimes be beneficial to companies that issue debt, since it can bolster revenue and cash flow. They’re predicting only a 10% decrease in corporate cash flow if a recession happens—not anywhere near the 25%-40% declines that have happened in downturns over the past 3 decades.
- Over the last few years, many companies seized the opportunity to refinance their debt at low interest rates. Those rates that were locked in even after the recent increases from the Fed. That also extended the “maturity wall,” or the time frame for debt maturity. Three-quarters of high-yield debt and loans won’t mature until after 2025.
- Bad liquidity is one reason that high-yield debt has been slammed, particularly CCC-rated bonds. “Brokerage provision of liquidity is worse by multiple times compared to 2008…their provision of liquidity is nonexistent,” says Loome, who is overweight on CCC bonds himself. But as inflation, recession worries, and Fed policy starts to ease, that would open back up the new issue market. But by then, investors will likely have already missed the chance to buy up junk bonds at low prices. That’s why, Loome advises in the article, now is a good time to jump on junk bonds, such as the CCC-rated bonds that Loome favors. The yield is higher, and CCC-rated bonds tend to outperform when the market rebounds.
Though investors could own high-yield ETFs or individual issues, the article advises to instead buy an actively-managed fund with an expert portfolio manager at its helm to navigate you through this “tricky economic environment.”