The junk bond market is on fire this year as yields hit a record low

Junk bonds aren’t so junky anymore, with a strong fundamental backdrop helping to underpin what traditionally has been one of the riskiest sections of the financial markets.

Yields in the $10.6 trillion space for the lowest-grade bonds in terms of quality are around historic lows after a tumultuous year that saw corporate America face down the Covid-19 pandemic and come out on the other side with balance sheets looking extraordinarily strong.

Bond yields decline as prices rise; the two have an inverse relationship to each other.

Most recently, the junk bond sector collectively was yielding 3.97%, according to the ICE Bank of America High-Yield index. That’s up from a record low of 3.89% on Monday.

In March 2020, during the worst of the pandemic volatility, the yield was at 9.2%. This is the first time in history that the collective yield for junk has been below the rate of inflation as measured by the consumer price index, which rose 5.4% in June year over year.

At the same time, spreads, or the difference between high-yield and Treasurys of similar duration, have fallen to 3.05%, just off the lowest since June 2007.

While the prospect of the poorest-rated companies being able to pay less than 4% to issue debt might raise the specter of a bubble in the making, most bond pros don’t see any major problems brewing, at least not yet.

“Corporations weathered the storm last year and have positioned themselves really well,” said Collin Martin, fixed income strategist at Charles Schwab. “Couple that with yield-starved investors going into anything and everything that offer better than a 0% yield, and it’s really the perfect storm to see spreads drop to those pre-financial crisis levels.”

Companies have built huge cash positions over the past several years, with total liquid assets at nonfinancial companies totaling $6.4 trillion through the first quarter of 2021, according to the Federal Reserve. That’s up nearly 50% just since 2018.

They’ve built cash as they’ve taken advantage of interest rates that the Fed has kept around record lows, a situation that’s proven particularly advantageous for lower-quality companies.

High-yield debt issuance has totaled $298.7 billion in 2021, up 51.1% from the same point in 2020, a year itself that saw a record-smashing $421.4 billion in junk issuance, according to SIFMA data. At the same time, investment-grade issuance has plunged 32.7% this year.

For investors, returns have been underwhelming. The $9.3 billion SPDR Bloomberg Barclays High Yield Bond ETF is barely positive for the year, though it does carry a yield of 4.21%.

While investors have been avoiding ETFs that trade in the high-yield market – the above-mentioned JNK ETF actually has seen outflows of $3.34 billion in 2021 – mutual fund and institutional investors have been willing to take on the risk to capture some yield.

“It’s a tough world as an investor, because valuations are awful but fundamentals are pretty good. Usually, fundamentals win out,” said Tom Graff, head of fixed income at Brown Advisory. “We’re pretty cautious on high yield. We own some. That risk-reward is so skewed right now, but you need to be realistic. It’s probably not going to go the other way anytime real soon.”

Like others who spoke about junk, Graff said investors can protect themselves by moving up the quality ladder – single- or double-B companies rather than the riskier C-rated.

Part of that story is an interesting reversal in dynamics for the broader bond market.

One of the big worries for the past two years has been the increase in what bond pros call “fallen angels,” or companies that were investment grade but have slid down the ladder. However, that narrative has changed, with investors now looking for “rising stars,” or companies that are climbing in credit quality.

Companies that once were investment grade and descended into speculative have raised the overall profile of the lower-graded parts of the market, and themselves could keep moving higher as their balance sheets improve.

Some examples of firms moving up the ladder through this year are First Energy, Murphy Oil and Booz Allen Hamilton, according to Moody’s Investor Service. Those heading in the fallen angel direction include Darden Restaurants, Delta Air Lines and General Motors.

“Because of all the downgrades that we saw last year, the credit quality in the market is higher than it’s ever been historically,” said Bill Ahmuty, head of the SPDR Fixed Income Group at State Street Global Advisors. “That’s helping to drive overall yields lower and spreads a little lower.”

Wall Street is expecting the level of companies moving up the quality scale to increase considerably through 2022 after little change in a 2020 market that saw a near-record amount of fallen angels.

Citing Barclays data, Ahmuty said rising stars will account for four or five times as much debt as fallen angels through 2022. At the same time, default levels are projected to be well below historical averages.

“High-yield indices are higher in credit quality. You have lower projected default rates and you have this component where you’re going to see rising stars over the next couple of years,” he said. “There’s a good fundamental backdrop there.”

One element that could spoil the high-yield party is inflation.

The CPI’s 13-year high in June is another signal that inflationary pressures remain and are a longer-term threat to push up interest rates. Since yields and prices move in opposite direction, higher bond yields would eat into capital price appreciation for bondholders, and especially hurt those in funds.

The Federal Reserve has vowed to stay on the sidelines until its employment objectives are met, but the threat of a tighter central bank always looms over the bond market.

“What kills a credit rally is the Fed tightening. More hawkish than expected rhetoric from the Fed can kill a credit rally as well,” Martin, the Schwab strategist, said. “We’ve seen very high inflation spikes and indications from the Fed for more hikes than anticipated. But the markets are just shrugging it off.”