An uptick in earnings among riskier U.S. companies is bolstering investor confidence that an epic rally in junk bonds can last a little longer.
After six straight quarters of year-over-year declines, earnings of low-rated companies increased 14% in the second quarter and 72% in the third quarter, according to Bank of America Merrill Lynch. At the same time, defaults slowed following a wave of bankruptcies in the energy sector.
Because of those factors, some investors and analysts say junk bonds— issued by companies that are often small and burdened by debt—could do much better than might be expected after such a strong year.
“From my vantage point, fundamentals are the most important thing” and “they’ve modestly improved,” said Michael Contopoulos, head of high-yield strategy at Bank of America, noting stronger earnings and steady oil prices have reduced risks.
The average junk bond yield was 5.86% Thursday, a two-year low but above the sub-5% levels it reached in 2014. Despite the low yields, many investors still view junk bonds as attractive at a time when the 10-year Treasury note yield is below 2.5% and stock valuations are widely seen as inflated.
Among the many junk-rated companies that had better earnings was Sprint Corp., which reported a 17% increase in adjusted earnings before interest, taxes, depreciation and amortization in the quarter ended Sept. 30 from a year earlier. Its 7.625% bonds due 2025 last traded at around 107 cents on the dollar, up from 75 cents on the dollar in June, according to MarketAxess.
The Bloomberg Barclays U.S. Corporate High Yield Index returned 17.1% in 2016. That was its best total return since 2009 and better than those produced by all three major stock indexes, as well as investment-grade corporate bonds and U.S. Treasurys.
Such a performance almost certainly can’t be replicated in 2017. Unlike stocks, there is a limit to how much bonds can rally because they mature at 100 cents on the dollar.
As bond prices rise, their yields decline. Before last year, junk bonds had produced double-digit returns four times in the previous 10 years and each time returns were much lower the following year.
Still, many investors and analysts are fairly optimistic about how junk bonds will perform.
Of six large banks surveyed by The Wall Street Journal, four project positive returns for junk bonds in 2017. J.P. Morgan Chase & Co. is the most bullish, predicting an 8% return. Wells Fargo & Co. is projecting 5% to 6%, while Bank of America Merrill Lynch is estimating 4% to 5% and Goldman Sachs Group Inc. is expecting 3.2%.
“High yield is a pretty resilient asset class,” said John McClain, a high-yield bond portfolio manager at Diamond Hill Capital Management in Columbus, Ohio. Though the market hit a rough patch in early 2016 as recession fears increased and sellers had trouble finding buyers, “that got fixed very quickly,” he added.
Of course, junk bonds still face risks. They are especially sensitive to economic downturns, sometimes picking up signs of stress before the stock market.
Though they aren’t as vulnerable to rising Treasury yields as investment-grade corporate bonds, junk bonds likely would decline in price if the Federal Reserve raises interest rates more quickly than expected and government bond yields increase sharply. That is especially true for higher-rated bonds with lower yields.
One wild card is the volume of new bonds added to the market. While bond sales tend to drop off during times of market stress, robust issuance can also depress prices of outstanding debt due to supply-demand dynamics.
Unlike the investment grade bonds, which set a record for issuance in 2015 and nearly matched that total last year, the volume of new high-yield bonds has declined in recent years, totaling $261 billion in 2016 compared with $269 billion in 2015 and a record $359 billion in 2013, according to Dealogic.