In December 2008, as the “world was ending,” US junk bonds hit a record high yield of 23.26%. Forecasts of financial Armageddon were widespread, and few could envision a scenario in which subordinated bondholders would receive anything but pain.
Note: throughout this post, we use the ICE BofA US High Yield Index as the high yield bond proxy.
But the world did not end in December 2008. And over next five years, US junk bondholders would receive nothing but pleasure, earning a record return of 21% per year.
Fast forward to today and we have reached the polar opposite extreme, with US junk bonds hitting an all-time low yield of 4.76%.
With the Fed promising to hold interest rates near 0% for at least the next few years, investors are once again reaching for yield.
In recent weeks, such reaching has only been rewarded, as yields have continued to fall. But the inevitability of bond math is lurking…
Lower starting yields = Lower future returns (on average).
And at 4.76%, this suggests the prospective returns for junk bonds in the US have never been lower.
To be sure, a low yield can go always lower and it can take time before a poor risk/reward translates into a poor return.
For instance, in December 2004 US junk bond yields hit a cycle low of 6.86% (back in those days, that was considered “low”). These bonds would go on to gain an additional 21% (total return) until they peaked in May 2007. But they would soon give all of that return back, and by December 2008 buyers of junk bonds from December 2004 had a cumulative loss of close to 22%.
Will the same thing happen today?
No. Every time is different and we are in uncharted territory here. Expecting exactly the same outcome as the past would be a mistake.
The best we can say when high yield becomes low yield is that the risk/reward has changed, and not for the better. Investors would be wise to lower their expectations for future returns and understand that a 0% Fed Policy does not mean zero risk.
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Disclaimer: All information provided is for educational purposes only and does not constitute investment, legal or tax advice, or an offer to buy or sell any security. For our full disclosures, click here.