Record low yields on junk bonds have led Morgan Stanley to downgrade them and advise investors to reduce their holdings. Even in good economic times, junk bond are riskier than investment grade bonds and are supposed to pay significantly more interest as a risk premium. However, today’s weak economy increases the risk of default by junk bond issuers.
Junk bonds are just not paying investors enough for the added risk. The difference between the junk and investment grade bond yields (the spread) has tightened considerably. This tightening is indicative to some that junk bond prices are headed lower, which would raise yields and increase the spread back toward a normal level.
“Risk/reward for the asset class is less attractive today than at any other point this year,” Morgan Stanley analysts Adam Richmond and Jason Ng were quoted as saying, adding: “The main driver of our downgrade is unattractive total return prospects going forward” (“Morgan Stanley Recommends Investors Reduce Junk Bond Holdings,” Bloomberg).
Yet money continues to flow into junk bonds and other unsafe assets as investors search for yield. $3.63 billion of new money flowed into junk bonds the week ended Sept. 19, the second-biggest volume ever, according to the article, citing data compiled by EPFR Global.
The downward pressure on yields in general comes from the Federal Reserve, which plans to keep interest rates on “safe” money like U.S. Treasury bills near zero for at least another three years. Yields on junk bonds were 6.95 percent on Sept. 19, an “unprecedented” low, according to Bank of America Merrill Lynch index data.
Page Perry is an Atlanta-based law firm with over 170 years of collective experience maintaining integrity in the investment markets and protecting investor rights.