Bad omen: Junk bonds are getting trashed

Matt Krantz | USA TODAY

Junk bonds are getting trashed - leading to the biggest mutual fund closure since the 2008 financial crisis - and raising a potentially a bad omen for stock investors, too.

The iShares iBoxx $ High Yield Corporate high-yield exchange-traded fund (HYG) is down 14% from its highest point over the past year - a massive downdraft that's already causing major dislocations in this market. The high-yield ETF has fallen to its lowest levels since 2009 - when the wounds from the financial crisis were still fresh.

Pain is getting so bad the Third Avenue Management firm that specializes on risky bonds is liquidating and preventing investors from pulling their money out of its roughly $1 billion junk bond fund called the Third Avenue Focused Credit fund. It's the biggest failed mutual fund since the Primary Reserve Fund in 2008, says Reuters.

Junk bonds, or "high yield" bonds, are riskier bonds sold by companies with lower credit ratings. Investors buy these bonds, despite their higher risk, because they pay higher interest rates than bonds sold by more secure companies. With interest rates hovering around 0% for so long, investors who need income have been taking on more risk to boost returns. Junk bonds are yielding 5.21 percentage points higher than government securities with similar maturities - a nice kicker considering that highly rated companies are yielding just 1.42 percentage points above Treasuries, according to data from Bank of America Merrill Lynch.

But that risk is starting to backfire and some think the junk-bond market's trouble could get much worse. "Unfortunately I believe the meltdown in high yield is beginning," says investor Carl Icahn on Twitter. Jitters are intensifying over junk bonds. The Markit CDX North American High Yield index - a measure of how nervous junk bond investors are - is close to a three-year high, says Bloomberg News.

What's concerning, too, is what the meltdown in junk bonds mean for the stock market. High-yield bonds and stocks typically "move in the same direction," says Diane Vazza of Standard & Poor's. But junk bonds started to decline in November to the point that they are down 1.1% this year through November.

"Some worry that a drop in lower-rated bonds portends future losses in (stocks), or that it is a harbinger of a looming recession. While this remains to be been, it is highly likely speculative-grade bonds will finish the year at a loss," according to an S&P report to clients.

But it's too soon to panic, says Sumit Desai, fixed-income analyst at Morningstar. The Third Avenue Focused Credit fund is more of an exception than the rule in that it invested in highly distressed credits, he says. The fund specialized on bonds issued by companies in bankruptcy or in restructuring that are very difficult to trade, Desai says. "This is an outlier," he says. "But it's a time to make sure you understand what you own and if you're comfortable with the risks."

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