Yield vs. Safety Of Principal
If an investor was given the opportunity to invest in two nearly identical
bonds with one bond paying 2% per year and the other paying 6% per year, logic
says most would choose to invest in the higher-yielding bond. In the real world,
the bond paying 6% also comes with a higher risk of default. Therefore, when
investors start to become more concerned about the economy and rising bond
default rates, they tend to gravitate toward lower-yielding and safer bond
ETFs, such as IEF, relative to higher yielding alternatives, such as JNK. The
chart below shows the performance of JNK relative to IEF. The chart reflects
a bias toward return of principal over yield.
Some cracks have started to appear in the credit markets in 2016. From CNBC:
The default rate for high-yield bonds has risen to the highest level
in six years, and a top bond analyst sees more bad news ahead for investors
in so-called junk bonds....Defaults are only likely to increase over the
rest of the year, predicts Diane Vazza, S&P's head of global fixed
income research.
The concepts illustrated on the chart below are described in this video
clip.
Potential Problems In The Oil Patch
Longer-term, if the economy flipped into a recession, the bulk of the defaults
could come from the energy sector. From Bloomberg:
Wall Street's biggest banks need to set aside more cash to cover losses
as low oil prices take their toll, according to Moody's Investors Service.
Goldman Sachs Group Inc., Morgan Stanley, JPMorgan Chase & Co., Bank
of America Corp. and Citigroup Inc. would need an additional $9 billion
to cover souring oil and gas loans in the worst-case scenario, the ratings
firm said Thursday in a report.
Increased Stress In China's Bond Market
When U.S. stocks sold off early in 2016, one of the market's principal concerns
was the health of China's economy. Those concerns could resurface in the coming
months. From Bloomberg:
Chinese companies canceled more than double the amount of bond offerings
in March compared with a year earlier, as mounting defaults increased financing
costs...The surge in scrapped offerings reflects investors' growing concern
about default risks amid the worst slowdown in a quarter century.
As China looks to shift to a more internally driven consumer economy, it is
possible some companies will not survive the transition. From Bloomberg:
China's top corporate bond underwriter said defaults will increase this
year, casting a cloud over the market after record offerings in the first
quarter helped refinance debt..."There will probably be many credit events
caused by liquidity problems," said Huang Ling at the Beijing-based firm,
which Bloomberg-compiled data show underwrote the most corporate bonds
excluding notes regulated by the central bank in the first three months. "Some
external events may trigger withdrawal of lending by financial institutions."