Junk bond yields slide as rising defaults don’t scare buyers

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Wall Street’s rally of the last two weeks also has stoked more buying in the ‘junk’ corporate bond market -- enough so to send a benchmark of average junk yields into single-digits for the first time in more than a year.

The average annualized yield on KDP Investment Advisors’ index of 100 junk issues fell to 9.77% at the end of last week, the lowest since June 2008.

The index’s yield had rocketed as high as 17.7% in December amid the credit markets’ meltdown and fears of global depression. But it has mostly been declining ever since as buyers have returned to the junk market.

Investors haven’t been fazed by the surge in bond defaults this year as the deep recession has left a rising number of junk issuers unable to make their debt payments. Through Friday, 184 companies worldwide had defaulted on their bonds this year, up from 48 at this time last year, according to Standard & Poor’s.

S&P estimates that the 12-month default rate of junk issues will reach a record 14.3% of the market by March. That would surpass the previous peak of 12.5% in the early 1990s.

Yet yield-hungry investors -- and traders looking to play hot markets that have momentum -- have been willing to take their chances in junk securities this year. The basic investment premise for junk bonds is that, even though a large chunk of them will default over time, the high interest rates on those that keep paying will more than make up for the losses in a diversified portfolio.

Compared with blue-chip stocks, junk returns already this year have been spectacular, as falling yields have lifted the market value of many issues. The Vanguard High-Yield Corporate bond mutual fund was up 23.4% for the year through Friday, compared with the 10.1% return on the Vanguard 500 Index stock fund. The average junk fund is up 27.2% this year, according to Morningstar Inc.

At this point, is it better to wait to buy junk? If economic data worsen and the stock market slides again, junk bond prices would almost certainly go south as well, driving yields higher. How much higher is the question.

After falling to 10.24% on June 15, the KDP index yield quickly rose back to 10.82% by June 23 as the stock market began to sell off. But then the yield mostly treaded water until the sharp break lower that began the week of July 13.

Investors and traders already know that junk defaults are likely to reach unprecedented levels next year, and that still hasn’t scared them off. What would it take?

-- Tom Petruno