Like stocks, junk bonds show investor jitters after yields fall to record lows

The stock market isn't the only place that's been signaling jitters among investors. The $2.3 trillion market for risky U.S. corporate debt has also been under pressure.

A five-year rally in junk bonds abruptly stalled last month. As with other higher-risk investments, investors have pulled back mainly because they worry about the end of the Federal Reserve's policy of near-zero interest rates. Investors expect the central bank to raise rates sometime next year, and that means the value of bonds currently held in portfolios will fall.

Junk, or high-yield, bonds are sold by companies with relatively high debt in comparison to their income. If yields on safer bonds like Treasurys were to climb, they would draw more investor interest. Companies selling junk bonds would then have to increase their yields to compensate investors for the higher risk. Doing so would diminish the value of junk bonds currently in circulation.

In July, those concerns hit the market, leaving junk bond investors with a 1.3 percent loss for the month. It was the worst monthly performance since June 2013.

Junk-bond yields have fallen so far that many investors now feel the risks outweigh the potential return. Five years ago, the average junk bond yielded 11.5 percent. By June, the yield had dropped to a record low of 4.83 percent, according to data from the investment bank Barclays.

As a result, investment advisers have become less enthusiastic about recommending junk bonds to clients.

There is often some role for high-yield bonds in investors' portfolios, but "there's a time to dial it up, and a time to dial it down," says Darrell Cronk, deputy chief investment officer at Wells Fargo Wealth Management. "Now is a time to dial it down."

Cronk says junk bonds may continue to slump as the economy improves and investors push up Treasury yields in anticipation of the Fed nearing its first interest rate increase since May 2006.

"The risk-reward trade-off is not that attractive anymore," says Collin Martin, senior fixed-income research analyst with the Schwab Center for Financial Research. "We just don't think that investors are being compensated for the risks involved in high-yield bond investing."

The market for risky bonds has become more mainstream since the 1980s, when trading was dominated by Michael Milken, the junk-bond financier, and his now-defunct firm Drexel Burnham Lambert. In those days, the market made headlines for helping fund takeovers of companies such as RJR Nabisco. Milken's reign as the king of junk bonds ended in 1989, when he pleaded guilty to securities fraud, defrauding a mutual fund and other felonies.

Investors plowed $55.01 billion into junk bond mutual funds last year, more than double the $22.1 billion total for 2009, according to data from the Investment Company Institute. Signs now suggest that investors have started pulling back. As the high-yield market started to wobble in June, investors withdrew $4.9 billion, according to the most recent data from ICI.

The recent outflows came as Fed Chair Janet Yellen said that she was concerned that investors were becoming complacent about the risks of investing in high-yield bonds.

Yellen told reporters in June that the market was showing evidence of "reach-for-yield" behavior, when investors focus on return irrespective of risk. One sign of this behavior is the fact that investors have been demanding less of a premium to hold high-yield debt compared to high-quality government debt.

At the start of 2012, investors received a yield premium of 6.99 percent over Treasury notes, which are widely considered to be risk-free. By June, that cushion had fallen to 3.23 percent.

Some investors say that the fall in junk-bond yields is justified because the risk of companies defaulting on their debt has declined.

Company executives have taken a more cautious approach to managing their businesses, says James Keenan, a managing director at fund manager BlackRock, who oversees the company's corporate bond business. Instead of spending money on expansion, they're focused more on paring debt. Many companies have used the proceeds from bond sales to refinance their existing debt at lower rates.

"We're in an overall pretty healthy economic environment, and most of these corporations have pretty stable balance sheets," Keenan says.

The number of companies defaulting on their debt has fallen significantly since the Great Recession ended in June 2009. That year, 195 U.S. companies defaulted on $516.1 billion of debt, according to data from the ratings company Standard & Poor's. By 2013, the total had dropped to 45 companies defaulting on just $64.9 billion.

Investors should see the recent sell-off as an opportunity to buy, providing that defaults remain low, suggests Gershon Distenfeld, director of high-yield debt securities for AllianceBernstein. Since the sell-off, the average yield on junk bonds has climbed from the record low it reached in June to 5.64 percent.

At the same time, investors should also expect lower returns. Junk bonds have delivered a sizzling average annual return, including interest payments, of 12.6 percent over the past six years, according to data from Barclays. By comparison, the Standard & Poor's 500 index has returned 9.7 percent annually, including reinvested dividend payments, over the same period. In coming years, Distenfeld foresees returns averaging between 5 and 7 percent for high-yield bonds.

"Unless you can time it really well, you're going to be better off having stayed in the marketplace, as long as you recognize that you're going to have more modest returns than you once had," Distenfeld says.