Yields on junk bonds may look attractive, but investors should be wary of them as the recession looms.
Barron’s Staff Illustration; Dreamstime (1)
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Investors have been hit on all sides this year, with stocks, bonds and cryptocurrencies losing big. For the first time in years, however, rising bond yields have brought benefits to retirees and other income-seeking investors.
While bond prices may continue to fall as the Federal Reserve raises interest rates aggressively to outperform inflation as yields and prices move in the opposite direction, the higher yields now secured could pay off in the long run. The Bloomberg Barclays Aggregate Bond Index fell 11.5% for the year, but many key bond yields have risen to 3.3% or higher.
These returns provide a cushion against further price losses, said Christine Benz, director of personal finance and retirement planning at Morningstar. While they may not fully offset any losses if bond prices fall further, they will do a better job than before to maintain the overall performance of retirees. (Individual investors mainly face losses on bond funds. If you buy an individual bond and hold it until maturity, you will not see any of the price fluctuations that occur with interest rate changes.)
In addition, with higher quality bonds offering better returns than they have for years, investors do not need to venture into more risky corners of the market in search of income. “Higher yields come to you with safer bonds,” Benz said.
So what should retirees do right now? For starters, as painful as the first half of the year may have been, now is not the time to give up your bonds.
“Now that interest rates have been restored, there is an opportunity out there,” said Brad Rutan, chief investment officer and investment product specialist at MFS Investment Management. “That’s what everyone expected.”
The yields on the 10-year government reference bond are 3.23%, compared to 1.63% at the beginning of the year. Yields on 7.4-year corporate bonds with a BBB rating are around 5.2%, well above the level of 2.55% where they started at the beginning of the year and about where they were during the Covid-19 crisis , said Adam Abbas. , co-head of fixed income at Harris Associates, which manages the Oakmark Funds. This is the lowest level of investment grade bonds, but their average default rate has been a tiny 0.06% over the past two decades, Abbas said.
The spread of these bonds in bonds – a measure of how much investors are rewarded for taking additional risk against risk-free government bonds – has widened to the 60th-75th percentile, depending on the sector and maturity. At the beginning of the year, spreads were about 40% more limited and the recent expansion means that investors are being rewarded more for the risk that a recession could increase corporate bankruptcies. (A difference in the 100th percentile will reflect very declining expectations.)
Benz recommends a fixed income bucket approach, with cash for expenses to be incurred over the next two or three years in cash, money for intermediate expenses in short-term bond funds and money for long-term expenses (for six to 10 years) in a mutual fund. capital with a broad market index such as
Vanguard Total Market Bond ETF (BND).
There are two corners of the bond market where yields or the prospect of inflation may seem tempting now, but they deserve attention, market observers say.
“First, securities protected by government inflation reflect expectations for future inflation and are not attractive at the moment if you believe the Federal Reserve will be able to curb inflation,” Abbas said. “The time to be at TIPS is probably over,” he said. However, if you think prices may continue to rise higher than expected, then a breakdown in TIPS makes more sense.
However, apart from shocks that could come from macroeconomic data or geopolitical conflicts, Abbas said the bond market was less likely to be shaken like when inflation data came in higher than expected in May. Inflation expectations have stabilized, in part because Fed officials have made it clear that they will do whatever it takes to reduce inflation, and last week raised the short-term interest rate by 0.75 percentage points, leaving open the possibility of future sharp increases.
The other area to look out for: High-yield bonds. The so-called junk bonds had a difficult year with
High yield SPDR portfolio bond
The ETF (SPHY) decreased by 13% for the year as yields increased. This fall in prices has made junk bonds more attractive, Abbas said, although lower-end bonds are still a better deal right now. Timothy Chubb, chief investment officer at Girard, a wealth consulting firm in King of Prussia, Pa., Said the high-yield spreads have not widened enough to hedge investors for the prospect of a mild downturn or further central interest rate hikes. bank.
No matter how thick the non-investment grade debt returns are, investors should remember that in an economic downturn, useless bonds tend to yield more as shares than other bonds, Benz said. If investors want to put their fingers in the category, he added, they could do so as part of a multi-sectoral bond fund that has the flexibility to hold certain high-yield holdings, e.g.
Loomis Sayles Core Plus Bond Fund
(NEFRX).
While bonds have fallen alongside stocks this year and did not provide the ballast they normally do in portfolios, rising returns mean that fixed-income investors can be relieved if the economy falls into recession. “If things get worse,” Abbas said, “the ballast will return.”
Write to Elizabeth O’Brien at elizabeth.obrien@barrons.com