Plunge in junk bond yields shrinks cushion for defaults

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Sticking with stocks was a good idea this year. Sticking with junk corporate bonds was an even better idea.

The junk, or high-yield, market has rallied powerfully since the stock market bottomed on March 9. Bond prices have surged, driving yields down sharply.

The average annualized yield on an index of 100 junk issues tracked by KDP Investment Advisors has plunged to 10.59%, down from an 18-year high of 17.7% in December.

The average junk bond mutual fund’s year-to-date total return -- price gain plus interest earnings -- was 21% through Thursday, according to Lipper/Reuters data. By contrast, the total return of the average domestic stock fund was 9.3%.

The same improved investor sentiment that has boosted the stock market also has lifted junk bonds, which are debt issues of companies rated below investment-grade: If the economy begins to recover in the second half, so should the finances of many now high-risk companies.

But as with the rallies in the stock and commodity markets, the question is whether the junk rally has gone too far.

‘It’s feeding on itself,’ said Kingman Penniman, head of KDP in Montpelier, Vt. In other words, the better the market does, the better it does, as money chases after it.

That’s great for ‘momentum’ traders, but ‘for fundamental investors, it’s murder,’ Penniman said.

What gives him pause, he said, is that the riskiest junk bonds have rallied much more since early March than those of better quality.

Yet even if you believe that the economy will get better in the second half, many financially challenged companies are too far gone to be saved, Penniman said. The credit outlook for those companies ‘is getting worse, not better,’ he said.

Indeed, defaults by junk companies are continuing to surge. A total of 25 U.S. companies defaulted on their bonds in May, bringing the year-to-date total to 101, according to Standard & Poor’s.

That left the trailing 12-month default rate at 8.25% of the junk bond universe. And S&P predicts much more to come: It is forecasting the 12-month default rate to reach 14.3% by April 2010.

‘It could reach as high as 18.5% if economic conditions are worse than expected,’ S&P warned in a report this week.

Obviously, investors know that defaults are going higher. So a bet on a diversified portfolio of junk bonds is a bet that interest income from the companies that keep paying their debts will more than offset losses from defaults.

The question is whether average junk yields now under 11% will be enough to compensate for the bombs that have yet to go off -- or whether it’s smarter to wait for an inevitable market ‘correction’ before putting more money into the junk bin.

-- Tom Petruno