The high-yield (junk) bond space has been under legitimate pressure over the last few months, and there may be even more trouble ahead. You can pick from any variety of negative developments to help you make a bearish case (if you’re so inclined): performance over the last six months has been dreadful, defaults are rising, redemptions at noteworthy funds have been crippling in some cases and spreads over U.S. Treasuries are on the rise.

What makes all of this even more eerie, however, is the fact that historically the high-yield space has correlated fairly closely with stocks. So, it’s a reasonable concern emerging among investors that trouble brewing in the credit markets could mean pain is due for the economy, which would send stocks lower. It is fair to say that deteriorating credit markets have been a harbinger for a peaking economy, which would indicate that a recession could be coming.

At Zacks Investment Management, we’re looking at these developments with caution, but at the same time we think it’s an over (and early) reaction to run for the exits. Some of the real story with high yields is being lost in translation, and some of the story isn’t being told at all. Here are four considerations to keep in mind.

Digging Deeper into the High-Yield (Junk Bond) Story

1. Think Quality – the key difference between the S&P 500 and the high yield space is quality. Companies listed in the S&P 500 are high in quality, versus the companies that are facing troubles in the credit markets now. The junk bond market is inherently lower quality, so if your portfolio is focused in high-quality, earnings-driven companies, you have much less – if anything – to worry about.

2. Size Matters – the funds that have made headlines recently for defaults, halted redemptions, or outright failure are small in size and not very representative of the junk bond market as a whole. The selling last week was sparked in large part by spreading anxiety over the closing of junk bond–focused mutual fund Third Avenue Capital Management LLC. But, if you look closely at Third Avenue’s holdings, you can easily see why they failed – more than half of the fund’s assets were bonds rated CCC or lower! There’s really little reason for a well-diversified investor to be that far-out on the risk curve when it comes to bond investing.

3. Concentrated Weakness – much like S&P 500 earnings this year, the severe weakness in energy, commodities and, by extension, materials is to blame. With crude oil falling more than 50% and other commodities slipping across the board, energy companies (particularly the highly indebted ones) are in some trouble. About 25% of this year’s junk defaults came from the energy sector, which also happens to make up a sizable portion of the high yield market in general. As such, weak performance of commodities/resource-related debt is disproportionately making the high yield space look worse than it is. The same story applies to corporate earnings – if you strip out the Energy sector, Corporate America is actually quite healthy.

4. It’s All Relative – even with recent defaults (and more to come), the overall default will still fall below the longer term average of 4+%. What’s more, the junk space only represents about 25% of total corporate bonds, so the weakness here is really a percentage of 25%. Fairly small overall. And lastly, few people are noting that we’re coming off one of the most attractive periods for issuance, when rates were low and money was easy. The market appears to be resetting itself more than anything, perhaps in anticipation of rising rates down the road. When you look at the spike in historical terms, we’re actually still below what we experienced in 2011.

Bottom Line for Investors

Staying out of the junk bond ‘mess’ (if you can call it that) is easy: just build a diversified portfolio that focuses on high quality.

All the Best and Have a Safe and Happy New Year!
– Mitch

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