If you’re looking for bonds to buy, make sure to steer clear of high-yield junk bonds.
First, they have always been on the high end of the risk scale… worse than Treasuries, municipals and high-grade corporate bonds. Now is not the time to take on undue risk.
Second, yield-hungry investors have been forced into this corner of the bond market as Treasuries have paid little to nothing for four years now. This is working to create a bubble in the junk bond market and investors will be quick to exit at the first sign of trouble.
What’s more, the correlation between junk bonds and the S&P 500 is quite high. Adding junk bonds to a long stock portfolio won’t reduce overall portfolio risk through diversification, as the theory goes. It will actually leave you overexposed to the long side.
When stocks falter, junk bonds tank… and that’s a recipe for disaster.
Take a look at the strong correlation between these markets…
As you can see, SPY and JNK mostly go up and down in tandem. But the relationship is even more pronounced on the downside.
While JNK usually trades higher when SPY trades higher, when SPY drops… it’s almost a sure bet that JNK will drop, too. And, JNK often falls further.
Just recently the S&P 500 pulled back a little more than 6%. JNK dropped about 50% further, losing 9% over the same time period.
So if you think junk bonds are a good place to grab yield… or diversify your stock portfolio… think again!
This is one corner of the bond market you definitely want to avoid.