The Danger Behind Purchasing Junk Bonds At Peak Complacency

There was an interesting discussion with MISH on his site this week where he looked at the return on junk bonds compared to what you are risking to receive that return.

The average return (or annual interest payment) an investor receives by buying into the Barclays High Yield Bond Index is 5.85% (high yield is a nice way of saying "junk" or "high chance of default"). If you invest $100,000 in this index you can expect to receive $5,850 in annual interest payments.

BCA recently finished a study concluding it was time to invest heavily in this sector. They believe that the average default on these bonds will be 3.0% over the next year.

On top of this 3.0% loss there is the expected 2.0% loss that will occur due to inflation (you can argue that inflation is running far higher than that level when you look at real life costs of living but that is a topic for another day). This gives you a real return of:

5.85% - 3.0% (defaults) - 2.0% (inflation) = 0.85%

As of this writing you can currently invest in a 10 year U.S. treasury bond for about 2.5%. This is considered a risk free rate where your only loss category comes in the form of inflation.

2.5% - 2.0% (inflation) = 0.50%

The estimated return difference between the junk bonds and the risk free bonds is 0.35%. Is that worth running the risk that the economy could slow down just a tiny amount which would cause junk bond defaults to surge? See the default rates explode in 2008 in the chart above (it is the mountain on the left).

Investors do not think this way at the tail end of a debt fueled mania. The old saying goes that "a rolling debt gathers no loss." This means that as long as there is a greater fool available to roll the current debt into a new loan, everything looks great on the surface. When that next greater fool becomes a little nervous and decides to hold on to his liquidity then the game is up and junk bonds will implode. 

This is part of the ebb and flow of a normal market cycle, and we are approaching the point where the tide will once again move out and the world will see who has been swimming naked.