Are junk bonds becoming the new equities?

It’s a well-known reality that high-yield bonds are generally more correlated to equities than they are to higher-quality bonds, but is it possible to actually substitute junk bonds for stocks?

That argument is being made on a selective basis by Noland Langford, founder and chief executive of Left Brain Capital Management.

“You keep hearing about bonds being in a bubble, but that’s the highest-quality bonds, like Treasury bonds, where there is the most interest-rate risk,” he said. “In other markets, such as emerging markets, high-yield corporates and lower-quality corporate bonds, there’s no rate risk; there’s only credit risk.”

While Mr. Langford is not advising a blanket switch from stocks to junk bonds, he does see an opportunity to reduce some equity market risk exposure by leaning more heavily on high yield bonds where the average spread over Treasuries is 650 basis points, or about 150 basis points over historical averages.
“There’s a lot of protection there if rates start to go up,” he said. “If interest rates go up, it means the economy is stronger, and that the ability of the high-yield borrowers to pay down their debt actually improves.”

Bob Rice, chief investment strategist at Tangent Capital, gave the strategy a backhanded endorsement, as long as it involves individual bonds or an actively managed bond fund, and not an indexed strategy.

“It’s not the dumbest idea I’ve ever heard,” he said of supplanting some equity market risk with high-yield bond risk.

“Assuming you’re picking bonds from companies with real balance sheets, the higher coupon will lower your sensitivity to an interest-rate move,” Mr. Rice added. “But a minus could be some price dislocation because of the illiquidity present in the bond market, so you have to have the ability to hold them.”
Mr. Rice stressed that such a strategy would be difficult to employ using indexed funds or ETFs.

“The best way to do this would be through direct ownership of the bonds, or make sure you’re investing behind a very intelligent active bond manager,” he said. “Do not touch a high-yield bond ETF because bonds are very idiosyncratic and the indexes can’t distinguish between factors related to balance sheets or sectors or what constitutes a default that will concern or attract an active manager.”

Of course, not everyone sees the use of junk bonds as a proxy for equities as such a clean transition.

“I started doing research on this about six years ago, and we saw something similar to it during the financial crisis when investors were replacing equities with structured credit strategies that blew up for being over levered,” said Jonathan Belanger, director of research at AlphaCore Capital.

“The essence of it is, you’re lightening up on your equity risk, but the credit risk is still very prevalent,” he added.

While Mr. Langford follows the logic that companies issuing high-yield debt will be in better shape as rates rise because higher rates represent a stronger economy, Mr. Belanger thinks it’s also important to consider the higher cost of refinancing debt as rates rise.

“If you’re afraid of higher rates, you will go to short-dated high yield, but then you still have default risk,” Mr. Belanger said. “We think folks might be understating the potential for default risk in high yield.”
Mr. Langford acknowledges the wrinkle of companies having to refinance at a higher rate, but he believes the inflated spread over Treasuries is more than enough to compensate for that risk.

The wild card here is that both arguments are forced to work from hypothetical scenarios because the last time there was a rising interest-rate cycle, which peaked in 1981, there wasn’t a high-yield bond index by which to gauge the impact of rising rates.

“There was no index back then, so the research is very spotty in terms of pricing,” said Mr. Belanger. “If rates go up, it might be good for high yield initially, but you have to think about down the road when that company needs to refinance at a higher rate. They can really fall under the weight of rising debt service costs.”