High-yield bonds lose their appeal amid ratings downgrades

For advisers, it’s time to start talking trash.

We’re not talking about your clients’ basketball prowess or choice of automobiles. We’re talking about their high-yield bond holdings, which have been performing worse than stocks.

The average high-yield bond fund is down an average 5.90% over the past 12 months including reinvested interest. That’s worse than the Standard & Poor’s 500 stock index, which is currently down 3.81% including dividends.

Your clients probably have two burning questions. Conservative in-vestors will want to know what possessed you to put them into a high-yield bond fund in the first place. Aggressive investors will want to know if it’s time to buy. (First answer: “For income.” Second answer: “Probably not just yet.”)

Junk bonds are long-term IOUs with questions about their issuers’ ability to make timely interest and principal payments. Because they have dinged credit, they pay higher interest rates than high-quality Treasuries. At the moment, high-yield bonds yield about 9.5%, said John Lonski, managing director and chief economist for Moody’s Capital Markets Research Group. So if your client is asking why you recommended a high-yield fund, that’s your answer: You won’t find a 9.5% yield anywhere else.

MISERABLY LOW RATES

Back in June 2014, junk bonds yielded a record low of 4.93%. Bear in mind that in the world of bonds, low yields mean high prices, and vice versa. “It was not a good time to buy high-yield bonds,” Mr. Lonski noted. Nevertheless, investors poured a net $19 billion into high-yield bond funds over 12 months ending June 30, 2014, according to Morningstar Inc.

One reason for their enthusiasm was the miserably low rates generally available elsewhere. Money-market funds yielded almost nothing, and the yield on the virtually riskless (at least from a credit standpoint) 10-year Treasury note was about 2.5%.

Unfortunately for investors, June 2014 was about as good as life got for high-yield bonds. Rating downgrades began to outnumber upgrades, and the global economy began to slow. By June 2015, things got even worse, said Kapil Singh, high-yield portfolio manager at DoubleLine. “You could see it in the new issue market,” he said. “Things were getting frothy.”

To make things worse, the commodity markets began to collapse. Oil, mining and energy issues were about 20% of the high-yield bond market before the commodity collapse, says Gene Tannuzzo, portfolio manager of the Columbia Strategic Income Fund (COSIX). Thanks to defaults and price decreases, energy and mining’s share of the high-yield market has shrunk to about 13%.

Can you invest in high yield without buying energy and other commodity issues? Sure, but it won’t help much. “Taking oil out of high yield is almost impossible now,” Mr. Singh said, noting that deterioration in the oil patch drives down prices in other parts of the high-yield market. “Oil is essential to the equation right now.”

REASON TO BE WARY

Mr. Singh is bearish on high yield, and DoubleLine Core Fixed Income Fund (DBLFX) slashed its allocation to below-investment-grade U.S. corporate bonds to 2.4% from 8.1% in May. He expects downgrades to increase and new issuance to fall. Moody’s Mr. Lonski pointed out that the default rate was 3.2% in December; the company expects it to rise to 4.4% by the end of the year. “There’s reason to believe it will approach at last 6%,” he said.

Other managers expressed similar worries. Tom Stolberg, co-portfolio manager for U.S. high yield strategy at Loomis Sayles & Co., said a recent survey of senior loan officers showed banks are tightening their lending standards.

“That’s not a good indicator for high-yield bonds,” he said. “As an asset class, high-yield issuers are the neediest for loans. If banks are tightening, that’s not a positive backdrop for returns.”

Global growth, or the lack of it, is another reason to be wary of high yield, Mr. Stolberg said: “If you look at the World Bank’s strategists’ outlooks, global growth has been revised down almost every quarter for two and a half, three years.”

Corporate profit growth, too, has been fizzling. Excluding energy, 244 S&P 500 companies have reported earnings. “They show fourth-quarter sales growth at a 0.6% annual rate and operating profits growing at 2.6% annually. That’s on the low side,” Mr. Lonski said. Overall, including energy, fourth-quarter S&P 500 earnings are expected to fall 5.24% year over year, according to S&P Capital IQ.

Despite their overall caution, managers say they are starting to find a few good values in the rubble. “From a bond market perspective, you have to ask where you’re being paid enough for recession,” said Columbia’s Mr. Tannuzzo. “This is the time when you’re supposed to be looking at the market and saying, “There are opportunities out there, and we need to pick our spots.’”

Mr. Stolberg is cautious. While he said current yields are a fairly handsome payment for risk, his fund is still “modestly” below its benchmark allocation for high yield. “We’re still invested, and it’s possible to find some very attractive opportunities despite things being so poor,” he said.

ONCE THE RAIN STOPS

The bond market is usually happiest when it rains. A slowing economy means lower interest rates, and lower interest rates mean higher bond markets. High-yield bond managers, however, are happiest once the rain has stopped: After a recession, high-yield bond funds can shoot the lights out. While a 9.5% yield is attractive, bear in mind that junk yields peaked at more than 20% in the wake of the 2008 financial crisis.

No one is predicting that kind of meltdown. DoubleLine’s chief executive, Jeffrey Gundlach, puts the odds of a recession this year at around 30%, and the company remains negative on junk. Moody’s Mr. Lonski puts the odds at 25% to 50%. “Although the latest yield of 9.5% is well above what’s likely to be the case in three to five years hence, there’s a significant risk of yields moving even higher,” he said.

For advisers who want to know when to get in, then, the answer probably is “not yet,” unless they are feeling particularly frisky about current economic conditions and the price of oil. “The reality is, I think we’ll look back and say, “High yield bottomed when oil bottomed,’” Mr. Tannuzzo said.

Very few people are willing to make that call yet.