An inverted yield curve adds pressure to lower-rated corporates.
Junk bonds have, on average, a much shorter duration than high-grade bonds. The current duration on high-yield bonds is 3.5 years compared to 7.10 years for investment-grade peers. It follows that junk bonds are pricing on the most expensive part of the yield curve, while investment grade corporates can take advantage of long-term lower yields.
Moreover, the risk of a recession is bearish for lower-rated corporate bonds, while it can be positive for highly-rated credits as they become an alternative to safe havens. As the yield curve steepens amid such a scenario, junk bonds will continue to suffer as investors fly to safety. At the same time, falling rates will help investment-grade bonds’ rate component to outweigh their negative credit spread component.
Overall, we remain defensive. We see more value in government bonds and quality corporates as uncertainty increases credit and default risk.
Do you still have an appetite for junk? Look at fallen angels.
Fallen angels in fixed income are those bonds that were originally issued with an investment-grade rating and have since been downgraded to a high-yield rating due to the issuer's adverse circumstances.
The best example is Ford Motors' bonds, downgraded to junk during the pandemic. The bonds now have a Ba2 rating from Moodys and BB+ from S&P. Ford senior bonds with three years maturity (US345397D260) offer a yield of 6.75% in yield and pay a coupon of 6.95%. Another example is Travel + Leisure, rated now Ba3 and BB- by Moddys and S&P, respectively, after being downgraded to junk in 2017. The bonds with April 2024 (US98310WAP32) pay a coupon of 5.65%, offering an overall yield of 6.7%.
Junk cash bonds or funds?
If the portfolio's capital amount is insufficient to guarantee proper diversification, buying into specific junk bonds can be risky amid a deteriorating macroeconomic outlook.
In that case, funds might enable investors to take broad exposure to the junk bond market while diversifying within this space. It’s fair to note that when you buy a corporate bond, you lock in its yield if you hold the security until maturity. Your investment will be sensitive to rates only if you wish to sell the bond before the notional comes due. Yet, if the company defaults on debt, you may lose all or part of your invested capital.
While your investment may still be affected by the default of one or more ETF holdings, the risk of losing all your capital is reduced to a minimum as the income you will receive and the value of the ETF will track several bonds. Yet, as interest rate rise and corporate spreads widen, the value of the ETF might fall, and you cannot lock in the yield like in a cash bond. Yet, maturing securities will be reinvested into higher-yielding bonds, increasing the income profile of the fund.
Please find below a list of ETFs that might help take exposure to the junk bond market:
- Fallen angels ETFs: iShares Fallen Angels High Yield Corporate Bond UCITs ETF (IBC7:xetr; WING:xlon), VanEck Global Fallen Angel High Yield Bond UCITS ETF (GFA:xmil; GFEA:xetr), Invesco US High Yield Fallen Angels UCITS ETF (FAHY:xetr, HYFA:xlon)
- High yield US funds: iShares USD High Yield Corporate Bond ESG UCITS ETF (UEEF:xetr), iShares USD High Yield Corporate Bond ETF (SHYU:xlon, IS0R:xetr), iShares Global High Yield Corporate Bond UCITS ETF (HYLD:xmil, IBC9:xetr)