Junk Bonds Prove Resilient Amid Stock-Market Jitters
April 03, 2011
NEW YORK -- Over the past two weeks, as the stock market's erratic performance has shattered the nerves of edgy investors, the junk-bond market, which usually marches in tandem with stocks, has been remarkably resilient. While stocks in the Dow Jones Industrial Average fell as much as 3% in a single day, and high-technology companies traded on the Nasdaq Stock Market fell even more, the high-yield, low-rated bonds known as ``junk'' bonds barely budged. That's a surprise, some analysts say, because the same events tend to have similar effects on both markets. Both respond positively to signs that the economy is strong and corporate earnings likely to grow, and tend to be heavily sold if investors fear earnings will dwindle. ``The high-yield market is the bridge between stocks and bonds,'' says Cyndy Shull, who manages the Phoenix High Yield Fund. ``There tends to be a close correlation with stocks because junk bonds are highly sensitive to what lower earnings say about the availability of cash flow to finance debt.'' While celebrating the junk-bond sector's strength, analysts and investors are puzzling over the meaning of this sudden divergence between high-yield corporate bonds and stock prices. ``What we think that this tells us is that the stock price plunge we saw (last week) had really little to do with a deep conviction that there's going to be a deep downturn in profitability,'' says Johnetta Torre, chief economist at Moody's Investors Service Inc. ``The resilience of junk bonds says there's little likelihood that earnings growth is going to slow to such an extent that debt repayments might be jeopardized.'' Mr. Torre's conclusion: Stocks were being sold more because they were overvalued than because investors feared a substantial erosion in earnings. Therefore, he feels that, even if the stock market takes a few more hits, a correction is likely to be short-lived. ``All this alarm may have been overdone to some extent,'' Mr. Torre says. To some extent, junk bonds have benefited from the recent stock-market turmoil. Junk bonds, which include bonds rated double B or below by agencies such as Moody's or Standard & Poor's, often are marketed to investors as an interest-bearing alternative to stocks. Studies by analysts at Merrill Lynch & Co. show that the sector's performance bears a much closer resemblance to that of the stock market than to other parts of the bond market, such as investment-grade corporate bonds or Treasury securities. And marketing efforts appear to have borne fruit. ``People are reallocating assets into bonds and out of stocks anyway,'' says Kathline Banda, portfolio manager at Loomis, Sayles & Co. in Boston. ``And to the extent there's going to be a divergence (between stocks and junk bonds), we'd expect the bonds to outperform.'' Indeed, some analysts say institutional investors are in the midst of reallocating as much as $300 million from stocks into junk bonds. That kind of cash injection will prove a strong technical reason for the market to outperform over the next few weeks as the money flows into the high-yield bonds. Ms. Banda is only one of several managers to have seen this kind of shift in assets. ``Pension-plan sponsors began looking at this months ago, and are doing it now,'' she says. This cash, she says, isn't ``hot'' money that will flow quickly out again on the first sign of weakness. Nor have these new investors shown any sign they're afraid the stock market's jitters will spread to junk bonds. No clients have called off presentations or tabled discussion of the idea of allocating new resources to this part of the market. The reason for the reallocation isn't hard to see. Merrill Lynch's aggregate index of Treasurys, highly-rated corporate bonds and mortgage-backed securities has posted a negative total return of 0.1% so far this year. In contrast, the investment dealer's high-yield-bond index has posted a positive total return of 3.2%. And the sector's ability to cast itself as a hybrid, able to combine the characteristics of stocks and bonds, has helped it outperform. But some analysts contend the stock market's roller-coaster performance over the last couple of weeks is sending out warning signals that junk-bond investors should heed. ``We've got a yellow flag up right now'' on junk bonds, says Fredda Biles, senior portfolio manager at IDS Fixed Income Advisers in Minneapolis. ``Give the markets some time, and I think you'll find the divergence between stocks and junk bonds disappears'' as the bonds themselves begin to show signs of weakness. For now, the fact that junk-bond investment managers tend to keep more of their portfolio's assets in cash than do their stock-market counterparts, coupled with the recent end to outflows from junk-bond funds, seem to outweigh the kinds of worries that have driven stock prices down, these bears say. ``Junk-bond managers, when they have faced redemptions, haven't felt the need to sell to meet those cash demands, and that's helped,'' said Martine Lovely, chief high-yield investment strategist at Merrill Lynch. But Mr. Lovely and other analysts caution that if stocks resume their downward march, junk bonds this time might follow suit. ``It remains true, fundamentally, that falling stock prices mean lower asset values for companies with junk bonds outstanding, even if those companies aren't publicly traded,'' Mr. Lovely adds. ``And in a falling or uneasy stock market, it's unlikely troubled companies would be able to stave off debt troubles by selling new equity capital as some folks did earlier this year.'' Both of these factors could hurt the rating on a bond, sending its price lower as investors seek a larger risk premium in the form of a higher yield.
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