Historical Performance of Junk Bond Mutual Funds VS Investment-Grade Bond Mutual Funds

Historical Performance of Junk Bond Mutual Funds VS Investment-Grade Bond Mutual Funds

When it comes to investing in bonds, there are many factors to consider, including the credit rating of the bond issuer, the yield offered, and the type of bond. One common comparison is between junk bond mutual funds and investment-grade bond mutual funds.

Junk bonds have a lower credit rating than investment-grade bonds and therefore offer higher interest rates to attract investors6. In this article, we will explore the historical performance of junk bond mutual funds VS investment-grade bond mutual funds and provide insights into investing in bonds through mutual funds and exchange-traded funds.

Historical Performance of Junk Bond Mutual Funds VS Investment-Grade Bond Mutual Funds:

  1. Junk bonds have a lower credit rating than investment-grade bonds and therefore offer higher interest rates to attract investors1.
  2. Junk bonds are generally rated BB[+] or lower by Standard & Poor’s and Ba or lower by Moody’s1.
  3. The rating indicates the likelihood that the bond issuer will default on the debt1.
  4. Historically, average yields on junk bonds have been 4% to 6% above those for comparable U.S. Treasuries1.
  5. U.S. bonds are generally considered the standard for investment-grade bonds because the nation has never defaulted on a debt1.
  6. Bond investors break down junk bonds into two broad categories: fallen angels and rising stars1.
  7. Fallen angels are bonds that were once rated investment grade but have since been reduced to junk-bond status because concerns have emerged about the financial health of the issuers1.
  8. Junk bonds follow boom and bust cycles1.
  9. High-yield bonds tend to perform better than investment-grade bonds when interest rates rise, as long as defaults stay low2.
  10. Mutual funds that hold intermediate-term, investment-grade bonds could benefit from the end of interest rate increases by the Federal Reserve3.
  11. Non-investment-grade bonds, or high-yield bonds, carry lower credit ratings from the leading credit agencies4.
  12. A bond is considered non-investment grade if it has a rating below BB+ from Standard & Poor’s and Fitch, or Ba1 or below from Moody’s4.
  13. Bonds with ratings above these levels are considered investment grade4.
  14. Credit ratings can be as low as D (in default), and most bonds with C ratings or lower carry a high risk of default4.
  15. High-yield bonds are typically broken down into two subcategories: speculative and non-speculative4.
  16. Junk bonds are bonds that pay higher interest rates because they have lower credit ratings than investment-grade bonds4.
  17. When a bond is rated Baa3 or higher by Moody’s or BBB- or higher by Standard & Poor’s or Fitch, it is considered investment grade4.
  18. Bonds rated Ba1 or lower by Moody’s or BB+ or lower by Standard & Poor’s or Fitch are considered non-investment grade4.
  19. Appreciating the difference between new and used bonds is important5.
  20. Tapping Treasuries through mutual funds and exchange-traded funds is a good option5.
  21. If you invest in junk bonds or emerging-markets debt, use a mutual fund or exchange-traded fund6.
  22. Keep your balance when investing6.
  23. Junk bonds have a higher risk of default than investment-grade bonds14.
  24. Investment-grade bonds are generally considered safer than junk bonds14.
  25. Junk bonds can offer higher returns than investment-grade bonds, but with higher risk14.
  26. The performance of junk bond mutual funds and investment-grade bond mutual funds can vary depending on market conditions2.
  27. Junk bond mutual funds may be more volatile than investment-grade bond mutual funds2.
  28. Investment-grade bond mutual funds may be more suitable for conservative investors2.
  29. High-yield bonds can be a good addition to a diversified portfolio2.
  30. It’s important to consider the historical performance of junk bond mutual funds compared to investment-grade bond mutual funds when making investment decisions12.

The Difference Between Junk Bond and Investment-Grade Bond Credit Ratings

Junk bonds are bonds that are rated below investment grade by credit rating agencies like Standard & Poor’s and Moody’s. Investment-grade bonds have higher credit ratings of BBB/Baa or above. Junk bonds have credit ratings below BBB/Baa, indicating a higher risk of default. The lower credit rating reflects a greater chance the issuer may not be able to repay the bond.

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Junk bonds pay higher interest rates to compensate investors for the higher default risk. Investment-grade bonds pay lower interest rates because they have a lower risk of default. The credit rating reflects the issuer’s ability to repay its debt obligations.

Why Junk Bonds Offer Higher Interest Rates

Junk bonds offer higher interest rates for a few key reasons:

  • They have a higher risk of default, so investors demand greater compensation.
  • They tend to be issued by smaller or less financially stable companies.
  • They are less liquid than investment-grade bonds, so investors require an illiquidity premium.
  • They are non-investment grade, so many institutional investors cannot purchase them due to investment mandates. This depresses demand and pushes up yields.
  • There is greater uncertainty about the issuer’s ability to repay the bonds.

The higher yields help attract investors despite the greater risks associated with junk-rated bonds. The higher interest payments help compensate for the higher probability of default.

Historical Returns of Junk Bond vs. Investment-Grade Bond Mutual Funds

Studies show that over long periods, junk bond mutual funds have outperformed investment-grade bond funds. For example, from 1997 to 2021, junk bond funds returned 7.4% annually compared to 5.3% for investment-grade bond funds.

However, junk bonds are also more volatile. In years when default rates rose, junk bond returns suffered significantly. But in periods of economic growth, junk bonds generated very strong returns.

Junk bonds offer higher long-term returns but require stomaching greater short-term volatility and higher risk. Investment-grade bonds provide more modest but stable returns. Investors must weigh risk tolerance against return potential when choosing.

How Investors Categorize Junk Bonds

Investors often segment the junk bond market based on credit quality:

  • Higher quality (BB): These issue bonds just below investment grade. They have the lowest default risk within the junk bond category.
  • Middle tier (B): These junk bonds have even greater default risk due to weaker financial profiles.
  • Lower quality (CCC): These are the riskiest junk bonds with the highest probability of default. Some call them “distressed debt.”

Segmenting junk bonds this way allows investors to compare relative risks and expected returns within the high-yield category. Not all junk bonds have the same default probability, so investors analyze sub-categories closely.

Fallen Angels in Junk Bonds

In junk bond jargon, “fallen angels” refer to bonds originally issued with investment-grade ratings that were later downgraded to junk status. This usually happens when the issuer’s financial profile deteriorates significantly.

Fallen angels tend to outperform other junk bonds because they have stronger issuer credit quality than original junk bonds. However, risks are still elevated compared to when the bonds had investment-grade ratings.

Rising Stars in Junk Bonds

“Rising stars” are bonds originally issued with junk bond credit ratings that improve to investment-grade status. This upgrade usually reflects strengthening issuer finances and decreased default risk.

Rising stars tend to generate healthy returns around the upgrade announcement. They also see reduced yields as their perceived risk declines with the rating improvement. Investors welcome rising stars as success stories.

Advantages of High-Yield Corporate Bonds

Key advantages of junk bonds include:

  • Higher yields than investment-grade bonds
  • Greater returns over full market cycles
  • Diversification relative to stocks and investment-grade bonds
  • Issued by companies with potential for improved credit quality
  • Opportunity to earn excess returns but requires thorough credit analysis
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Junk bonds offer healthy long-term returns for investors willing to accept higher volatility and manage default risks through diversification.

Disadvantages of High-Yield Corporate Bonds

The main disadvantages of junk bonds are:

  • Higher volatility and downside risk
  • Greater risk of default compared to investment-grade bonds
  • Lower liquidity than investment-grade corporate bonds
  • Subject to investor sentiment swings due to higher risk profile
  • Requires extensive credit analysis to manage default risks
  • Issued by companies with weaker financial health or smaller size

Junk bonds come with tradeoffs of higher yields but greater risks that investors must factor into portfolio construction decisions.

Junk Bond vs. Stock Market Volatility

Junk bonds are less volatile than stocks but more volatile than investment-grade bonds. During recessions, junk bond default rates tend to spike, causing sharp declines in returns.

However, over full market cycles, junk bond volatility has historically been lower than stocks. This is because bond investors get regular coupon payments that provide stability. Equity investors rely solely on share price appreciation for returns.

So junk bonds offer a middle ground between the lower volatility of investment-grade bonds and higher volatility of stocks.

Are Junk Bonds Riskier Than Traditional Bonds?

Yes, junk bonds carry greater risks than traditional investment-grade bonds for several reasons:

  • Higher historical default rates
  • Increased sensitivity to economic cycles and recessions
  • Lower credit quality of issuing companies
  • Reduced liquidity in junk bond market
  • Subject to investor sentiment swings

The tradeoff for higher risk is the potential for greater returns over the long run. But the higher probability of defaults makes junk bonds inappropriate for conservative fixed income investors.

What to Consider When Investing in Junk Bonds

When investing in junk bonds, key factors to consider include:

  • The higher historical default rates across junk bond categories
  • Diversification across many issuers to manage default risk
  • Focusing on higher quality BB-rated bonds which have lower default risk
  • Assessing the financial health of issuers through detailed credit analysis
  • Junk bond values during periods of rising interest rates
  • Maintaining a long-term investment horizon
  • Limiting exposure to the riskiest CCC-rated junk bonds
  • Combining junk bond funds with other asset classes to construct a diversified portfolio

Average Junk Bond Yields vs. U.S. Treasuries

As of August 2022, the average yield on junk bonds is about 8% based on the ICE BofA US High Yield Index. In comparison, the 10-year U.S. Treasury yield is around 2.7%.

So on average, junk bonds currently yield about 5.3 percentage points more than comparable Treasury bonds. This yield premium compensates investors for the higher default risks of junk bonds. The premium fluctuates over time based on economic conditions.

Investment-Grade Bond Credit Rating Standard

Bonds with credit ratings of BBB- or higher by Standard & Poor’s or Baa3 or higher by Moody’s are considered investment-grade. These bonds have lower odds of default and a higher degree of creditworthiness. Institutional investors commonly require bonds to be investment-grade.

Bonds with ratings below these thresholds are deemed non-investment grade or “junk.” The lowest credit rating category before default is CCC. Credit ratings directly influence bond yields and pricing.

How Junk Bonds Perform When Interest Rates Rise

Junk bonds face heightened risks when interest rates rise because:

  • Their prices fall more than higher quality bonds when rates increase.
  • It becomes more expensive for issuers to service their debt burdens.
  • Default risk increases in a weakening economy.
  • Investor appetite declines for risky assets during periods of uncertainty.
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However, junk bonds do provide some advantages when rates rise, including higher coupons and shorter maturities on average. But overall, their performance tends to lag in rising rate environments.

Benefits of Intermediate-Term, Investment-Grade Bond Mutual Funds

Key benefits of these mutual funds include:

  • Stable income from regular coupon payments.
  • Higher credit quality and lower default risk.
  • Reduced volatility compared to long-term and junk bonds.
  • Potential for modest capital appreciation as bond prices rise if rates fall.
  • Enhanced diversification across many bonds and issuers.
  • Professional fund management of the portfolio’s average duration.
  • An investment-grade focus appropriate for conservative fixed income investors.

Assessing Junk Bonds Based on Key Metrics

When evaluating junk bonds, key factors for investors include:

  • Default rates – analyze historical default rates by ratings tier.
  • Returns – evaluate long-term returns through cycles vs. investment grade.
  • Risk metrics – assess volatility, drawdowns, and risk-adjusted returns.
  • Diversification – understand correlations to stocks and other assets.
  • Credit analysis – perform individual and sector assessments of financial health.
  • Macro factors – gauge sensitivity to economic growth, recessions, and rate direction.
  • Current valuations – determine if yields adequately compensate for risks.

Junk Bond Default Risks

Junk bonds carry material default risks:

  • Historical default rates average 3-4% annually in junk bond indexes.
  • Default likelihood rises dramatically during recessions.
  • Lower quality issues default more frequently (10%+ for CCC bonds).
  • Certain sectors, like energy and airlines, have greater default risks.
  • Smaller issuers have higher failure rates than larger firms.
  • Leveraged buyouts and acquisitions increase default probabilities.

Managing junk bond portfolios requires careful diversification and credit analysis to minimize defaults.

Interest Rate Risk and Its Impact on Bonds

Rising interest rates reduce existing bond prices and values because:

  • New bonds are issued at higher rates, making existing bonds less attractive.
  • There is less incentive for investors to hold lower-yielding bonds.
  • Investors demand higher yields on existing bonds, forcing prices down.

Longer-term and zero coupon bonds face greater interest rate risk and price declines when rates rise. Managing rate risk is a key consideration across all bond categories.

Key Risks of Bonds and Mitigation Strategies

The primary risks of bonds include:

  • Interest rate risk – Manage with shorter durations and acquiring diverse yield exposures.
  • Inflation risk – Mitigate with TIPS or securities with adjustable coupons.
  • Credit risk – Diversify and conduct issuer analysis to avoid defaults.
  • Liquidity risk – Focus on actively traded securities.
  • Event risk – Monitor company and industry fundamentals.

Bond investors weigh risks against expected returns and diversify across sectors, credit quality, and maturities to construct resilient portfolios.

Conclusion:

Investing in bonds can be a smart way to diversify your portfolio and generate income. When comparing junk bond mutual funds and investment-grade bond mutual funds, it’s important to consider the historical performance of each.

Historical Performance of Junk Bond Mutual Funds VS Investment-Grade Bond Mutual Funds

Additionally, understanding the differences between primary and secondary bond issues can help you make informed investment decisions. By investing in bonds through mutual funds and exchange-traded funds, you can gain exposure to a variety of bonds and potentially reduce your risk.