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What Are the Concerns regarding Junk Bonds?

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Junk bonds in the news

Junk bonds have been in the news lately, mainly due to concerns about defaults. In the last part, we discussed the rating scales of major rating companies and what they mean for the credit risk and repayment ability of an issue.

Junk bonds have an iffy repayment ability even if they’re at the higher end of the junk rating scale. If the bonds find themselves in a rising interest rate environment, it becomes even more difficult to honor their commitments, given the state of their finances. The probability of defaulting rises.

Junk bonds are different from other types of bonds because they mimic equities more than bonds given their boom and bust cycles.

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Spreads have been rising

“Yield spreads” refer to the difference between the yields of two fixed income securities. They can either be of the same or different credit quality. Spreads are measured in basis points. One basis point is a hundredth part of a percentage point—1.0% = 100 basis points.

The BofA Merrill Lynch US High Yield Master II Option-Adjusted Spread measures the average difference in yields between below investment-grade bonds and Treasuries.

If spreads are rising or widening, credit conditions can be assumed to be worsening. Spreads also widen when growth is slow and economic conditions are worsening. In contrast, falling or tightening spreads coincide with faster growth and generally better economic conditions.

The above graph shows that spreads, as mentioned by the previous measure, rose in 2015. They started the year at a little over 500 basis points or 5%. They stood at over 700 basis points or 7% as of December 28, 2015. Yields also rose sharply.

This rise in the yields and spreads was due to by worries about junk bonds defaulting given the rise in the interest rates. Investors holding mutual funds that are invested in junk bonds (HYSAX) issued by companies like First Data (FDC), L Brands (LB), Berry Plastics Group (BERY), and AerCap Holdings N.V. (AER) should be vigilant about another aspect—liquidity. We’ll discuss this in the next part.

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