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Junk bonds, otherwise known as high-yield bonds, suffered mightily in 2015. The prospect of higher interest rates in the United States caused investors to flee from the junk bond market throughout the year. In the last three months alone, more than $8 billion was taken out of nearly 200 junk bond funds, according to market tracking firm Lipper.
Investors hoping that 2016 will be a better year for junk bonds may be disappointed. The Federal Reserve has signaled its intention to keep raising interest rates as the U.S. economy continues to grow at a gradual pace. This presents a significant headwind that could continue to plague the junk bond market next year.
Still, for brave investors, the sell-off in junk bonds has created some attractive opportunities, as yields are higher than they have been in years.
Be Aware of the Risks
Bonds carry several unique risks that investors should be aware of – and junk bonds are riskier in particular. The two major risks that junk bonds face in 2016 are interest rate risk and default risk.
Interest rate risk is the risk that a bond will lose value when interest rates rise. The reason is that when interest rates rise, fixed-income securities see less demand. Lower-rate issues are less valuable than newer, higher-rate bonds. As a result, existing bonds are repriced, meaning they are usually sold, which then causes their yields to rise in order to keep pace with the higher interest rate environment.
Next, investors should be cautious of default risk: the risk of a bond issuer defaulting on its debt obligations. Junk bonds are below investment grade, meaning they are securities that have a higher default risk than investment grade bonds and government bonds.
Investors should know that junk bonds carry higher risks than most other corporate bonds or government bonds. As such, junk bond funds typically offer higher yields, to compensate investors for that extra risk.
Potential Buying Opportunities Amid Junk Bond Funds
Given the forward-looking risks facing junk bonds, only brave investors with a stomach for volatility should wade into these waters in 2016. But for investors who prefer to buy when others are afraid, there are some potential buying opportunities among major bond mutual funds and exchange-traded funds.
For example, the Fidelity High Income Fund (SPHIX) navigated 2015 better than most high-yield funds. The portfolio stuck with higher-quality issuers, and as a result, the fund lost only 6% in 2015. And the fund offers a 5.8% yield, which could be attractive for yield-starved investors. This fund has earned a three-star rating from Morningstar fund ratings.
Lastly, two ETFs that could be attractive are SPDR Barclays High Yield Bond ETF (NYSEArca: HYG), which also has a three-star rating. The HYG fund lost 5% in 2015, which has pushed its yield up to 5.7%.
The other high-yield junk bond ETF that could be attractive to fixed-income investors is the SPDR Barclays High Yield Bond ETF (NYSEArca: JNK). This fund lost 6.8% in 2015, but its poor performance has created a higher yield opportunity. The JNK fund yields 6.3%, which is a higher level than most high-yield bond mutual funds and ETFs in its peer group.
The bottom line for investors is that while high yields seem attractive, junk bond funds carry above-average risks. With the potential for more interest rate increases in 2016, the high yields seen across the junk bond market could get even higher next year.
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