March 8, 2011 – Are Junk Bonds Peaking?

Featured Trades: (ARE JUNK BONDS PEAKING?)

 

3) Are Junk Bonds Peaking? There is no happier corner of the fixed income universe, which has been soaring like a bat out of hell for the past two years. Average yields for the bond class most sensitive to the economy have collapsed from 18% to near an all-time low of 6.8% a scant 440 basis points over Treasury bonds.

The ETF (JNK), which I have been aggressively recommending since 2009, has clocked a two year total return of close to 130% (click here for the piece). In fact, junks bonds have outperformed stocks by a substantial margin since the great bull market began in March, 2009.

If you look at the two year chart for (JNK) it virtually tracks the S&P 500 one for one, and therein lies the problem. When bonds act like stocks, what happens to bonds when stocks go down? That is a particularly pertinent question these days as stocks have more than doubled in two years, and are approaching grotesquely overvalued levels. After a move the stock index’s multiple from 10 to 15, with 16 a possible top, are junk bonds peaking out here? The better question might be whether high oil prices are poised to slam bonds worse than stocks.

A 440 basis point premium does not sound like much. It is pricing in the near absence of risk in this paper, as if they will live forever? When did I last see this movie? 2006? 2007? How short memories have become. It might be worth taking some money off the table here, and taking the hit in the return on your portfolio. Lowering the beta is prudent, especially if you are about to move from a ‘RISK ON’ to a ‘RISK OFF’ world for more than a day. No doubt, much of the juice in (JNK)’s recent moves came from Ben Bernanke’s QE2, which will end promptly on June 30. Do you really want to wait for the music to stop playing before you grab a chair?

If a client is holding a gun to your head, demanding that you reach for yield with some high risk exposure, then consider foreign junk exposure. At least there, you have the triple tailwinds of higher economic growth, appreciating currencies, and much higher yields.

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Time to Grab a Chair Before the Music Stops Playing?

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