Junk bonds are probably an asset class that very few traders are involved in. Junk bonds tend to correlate with the stock market, but junk bonds seem to trend more than stocks, which opens possibilities to make uncorrelated junk bond trading strategies.
This article explains what a junk bond is, why it correlates to the stock market, and how you can backtest this asset class. We backtest and look at a few junk bond trading strategies.
What are junk bonds?
Junk bonds are my one true love in the financial arena, and even that’s an understatement of my appreciation for this asset class….For me and junk bonds it was definitely love at first sight.
– Gary Smith, How I Trade For A Living, page 183
A bond is a fixed income security issued by a company (mostly companies, but it could also be a government entity). When the bond is issued it pays a coupon of x percent at N intervals per year. The bond is, in reality, a loan from the investors to the company.
The price of the bond might fluctuate depending on the overall interest level, the mood swings of Mr. Market, or improved or deteriorated prospects for the issuing company. When the price of the bond drops, the coupon yields more to reflect the increased risk. Thus, the value of the bond and the yield always move opposite.
It is called “junk” because they have a higher risk of default. A default happens when the issuing company is no longer able to pay the coupon. As you know, bonds are debt instruments with which an issuer agrees to pay investors interest payments along with the return of invested principal at a specified future date. Junk bonds are bonds issued by companies that are not in a good financial state and, therefore, have a high risk of delayed payment or defaulting — not paying their interest payments or repaying the principal to investors. So, they are corporate bonds that do not have an investment-grade credit rating.
If the risk of default is high, the higher the original coupon, but the yield fluctuates wildly over the life of the bond before it matures or is called back. Ratings are done by rating agencies, for example, Moody’s and Fitch.
Ratings below BBB and Baa are expected to have more defaults and are thus labeled “junk bonds”. Ratings higher than this mean the company has “investment grade”.
The term “junk” scares many potential investors and traders away from this asset class. But many well-known companies have junk bond status: Ford, Tesla, and Netflix are all below investment grade.
Keep in mind that junk bond yields have fallen dramatically over the last 40 years, just like Treasury yields. For example, in 1991 junk bonds yielded 17%, in 1998 11%, while they today have a minuscule 4% yield.
Does this reflect the true risk? Who knows, only time will tell. If you are a short-term trader it shouldn’t matter so much, except that the long-term trend might go down if rates go up.
The tailwind from falling interest rates has been significant. That, and the combination of “income” from the coupon, has made junk bonds compound at around 8% since 1980. This is the performance of Fidelity’s junk bond mutual fund:
Max drawdown has been 30% (in 2008/09), something that is significantly less than the S&P 500’s.
How does a junk bond work?
A junk bond is debt that has been given a low credit rating (below investment grade) by a rating agency because they are riskier, as the chances that the issuer will default or experience a credit event are higher. Given the higher risk, investors are compensated with higher interest rates, which is why junk bonds are also called high-yield bonds.
But technically, a junk bond is very similar to regular corporate bonds, as both represent debt issued by a firm with the promise to pay interest and to return the principal at maturity. However, junk bonds differ because of their issuers’ poorer credit quality.
Let’s look at the basics: bonds are fixed-income debt instruments issued by corporations and governments to raise capital. Investors buying binds are effectively loaning money to the issuer who promises to repay the money on a specific date called the maturity date while paying interests on a regular interval (mostly annually). At maturity, the investors are repaid the principal amount invested. This is the same with junk bonds, except that there is a higher risk of default and consequently, investors are offered higher interests to compensate for that.
Here is a junk bonds example: a startup named XYZ issues a five-year bond with a 12% annual coupon rate at $1,000 per unit. However, the company’s bond has a Fitch rating of BB. This means that the bond has a high risk of default, given the company’s startup status and financial history. However, an investor who purchases the bond earns an amazing 12% per year. So, with a $1,000 face—or par—value, the investor will receive 12% x $1,000 ($120 per unit purchased) each year until the bond matures.
What are the two types of junk bonds?
Companies with junk bonds usually have a credit rating of BB or lower by S&P or Fitch, or Ba or lower by Moody’s. Such corporate bonds are often classified into two sub-categories:
Fallen Angels: These are from companies that were once investment grade but have since been reduced to non-investment bond status because of their current financial status. Thus, a fallen angel bond is debt originally issued by an investment-grade company that has since been downgraded to “junk” status by a credit rating agency. The reason for downgrading it could be that the business is losing money, issues too much debt, or operates in an industry in secular decline.
Rising Stars: These are from companies that are just starting out and may not be in good financial standing. They are growth companies that are looking for funds to expand their projects and may not be profitable at that time. These companies may, at the moment, not be rated investment grade, but their ratings may rise in the future.
Are junk bonds worth it?
Junk bonds are not intrinsically good or bad investments; it depends on the individual bond and the investor’s appetite for risk and high returns. Some junk bonds may be an excellent option for investors seeking high returns. While junk bonds have a low credit rating, their higher yield compensates for the greater risk associated with a lower credit rating.
It’s important to know that just because a bond issuer is currently rated at lower than investment-grade counterparts doesn’t mean the bond will fail. Many junk corporate bonds do not fail to pay their interest and also return the principal at maturity. Moreover, when you consider that some of the companies behind these bonds are rising stars and may end up being more profitable than their investment-grade counterparts, you will understand why they can easily offer much higher returns.
But the situation varies from one bond issuer to another — not all junk bonds are the same. An investor must consider the specific circumstances of the company issuing them. Some junk bonds may be worth it for investors with a high risk appetite who desire high returns, it may not be suitable for risk-averse conservative investors.
Also, note that even though these bonds are considered riskier than other bonds, they may still be more stable than (not as volatile as) stocks. In other words, if you are looking for a risk level somewhere in the middle of a scale between the traditionally higher-risk stock market and the more stable lower-return, lower-risk bond market, junk bonds may be worth your bet.
Moreover, no stock or bond is guaranteed to bring returns without some form of risk, so it all comes down to choosing what you want to risk your money on. But don’t forget to investigate the bonds and weigh the pros and cons of each issuer against each other to determine whether or not a particular junk corporate bond is worth it for you.
But generally, junk bonds have been known to offer double-digit returns most of the time. For example, the returns were as high as 27.94% in 2003 and 54.22% in 2009, according to data from the Salomon Smith Barney High Yield Composite Index and the Credit Suisse High Yield Index (DHY). As with stocks, some years also made negative returns — for example, -26.17% in 2008 and -1.53% in 2002.
If you don’t want to risk it all in individual junk bonds, you can invest in junk bond ETFs to even out the risks while earning the accompanying huge returns.
Junk bonds vs stocks
According to a research paper by Alliance Bernstein, junk bonds have historically correlated 0.61 to the S&P 500 and 0.6 to MSCI World Index. This is pretty high and indicates that junk bonds are more correlated to the stock market than to the bond market.
Below is a chart showing the performance of HYG (a junk bond ETF, see more below) and the S&P 500:
The lower pane is S&P 500. Especially in times of market turmoil, we can see that both markets tend to drop sharply, and the correlation increases. Junk bonds offer no safe haven like government Treasuries.
Why would investors buy junk bonds?
Higher risk means higher interest rates (coupon). Fixed interest payments might avoid behavioral mistakes as you most likely continue receiving the coupon in times of stress, of course depending on the severity of the recession and the risk of default. Furthermore, bondholders get paid before equity owners if the company in question should go bankrupt – thus less risk.
Because of this, it’s fair to expect lower returns from junk bonds than stocks. Or is it?
Since junk bonds become an asset of their own in the early 1980s, the group as a whole has more or less kept pace with stocks, but with much lower volatility:
The graph above, made by AllianceBernstein, is a bit old, but the statistics still hold. Worth noting is the less volatility. If we risk-adjust the returns and compare them to the volatility, junk bonds have performed better than equities over the last 40 years.
However, keep in mind that the interest rates have been on a decline over the whole period. This has resulted in higher junk bond prices and the coupon needs to reflect the falling yields. There is, of course, no guarantee that this will continue, but it’s fair to assume that equities also will take a hit if rates turn around and head higher. Most likely, junk bonds would have fared much worse in 2008/09 if it wasn’t for the FED pumping in billions of dollars.
Junk bond ETFs
The easiest way to get exposure to junk bonds is to buy junk bond ETFs or mutual funds.
There are many junk bond ETFs but the two most popular are iShares iBoxx $ High Yield Corporate Bond ETF (ticker code is HYG) and SPDR Bloomberg Barclays High Yield Bond ETF (JNK). Both are highly liquid with a daily turnover of 44 and 11 million shares traded daily.
In this article, for backtesting purposes, we use HYG for the most recent time frames and Fidelity’s junk bond mutual fund (VWEHX) for longer time frames. The latter has a history back to 1980 and serves as a proxy for junk bonds in our backtests. However, there is no guarantee that VWEHX is a good proxy for the future.
Monthly seasonalities in junk bonds
Let’s start by looking at what has historically been the best months for junk bonds. We used Fidelity’s mutual fund for this test to get a decent amount of observations:
We buy the close of the previous month and we sell at the close of the current month. For example, January is the performance from the close of December until the close of January.
The worst month is September, exactly the same as in the stock market. (Please read our article called What is the worst month of the year for stocks?)
Day of week seasonality in junk bonds
Let’s backtest to look for any strong seasonalities based on the weekday. We use backtest by using HYG:
The first column shows which day it is, but we buy at the close and sell the next day’s close. Thus, “day of week” has a lag of one day. This means that the first row is the performance from the close of Monday until the close of Tuesday and so on.
Monday is the weakest day while Tuesday is the best. This might hint that there is Turnaround Tuesday effect in junk bonds.
Daily intraday seasonalities in junk bonds
The table below is the performance from the open to the close each day (we use HYG):
There is no money to be made intraday unless you are a very gifted trader. Just like S&P 500, the long-term gains come from the overnight edge.
One other trading seasonality in junk bonds
We tested another junk bond trading strategy that is based on a monthly seasonality:
The junk bond strategy holds on average just a few days but seems to have performed pretty well. We don’t want to publish the strategy because we trade it ourselves and we might publish it for our paying subscribers.
Trend-following in junk bonds (Backtest)
By using the optimization feature in Amibroker, we backtested many trend-following strategies. It works reasonably well, much better than in stocks, and below we have just a random example of one of the junk bond trend-following strategies we tested:
The strategy is long-only and the returns seem to be slightly diminishing recently. However, the CAGR is 9.6% while being invested 73% of the time, much better than buy and hold. Max drawdown is a tiny 6.5% and 2018 was the only year with negative returns.
If we flip the strategy and go short, the average gain per trade is also positive, but the headwind from the positive trend makes it less profitable than longs, and most likely not tradeable (until rates go up?).
If we use the same strategy in the S&P 500 the returns are much lower and more erratic. This means the “trends” seem to be much more robust in junk bonds than in stocks.
We want to emphasize, again, that junk bonds have had a powerful tailwind in the form of lower rates. Today we might be at crossroads where this is no longer. Only time will tell.
Turnaround Tuesday in junk bonds (Backtest)
The turnaround Tuesday trading strategy has been a very simple, yet effective trading strategy in the stock market. Does it work in junk bonds, is there a turnaround Tuesday in junk bonds?
Yes, there seems to be a similar effect, but not as distinct (below is from the close of Monday until close on Tuesday given two variables):
Junk bonds rating
Junk bonds are usually rated Ba1/BB+ and lower by popular rating agencies such as Moody’s, Standard & Poor’s, and Fitch. By researching the bond issuer’s financial health, these agencies assign ratings to the bonds offered.
Those agencies have a similar hierarchy to help investors assess that bond’s credit quality compared to other bonds. Standard & Poor’s and Fitch rate junk bonds BB+ or lower, while Moody’s rate them Ba1 and lower. See the table below for the ratings that fit into the junk bond status.
Junk bonds and interest rates
Generally, interest rate changes tend to affect bond prices and yield — as interest rates go up, bond prices will go down. Junk bonds may be less sensitive to short-term rates, but they closely follow long-term interest rates. But most times, it may take a recession for junk bonds to significantly underperform.
Given the Fed’s 0.25 basis point increase in interest rates in March 2022, many experts still think that US junk corporate bonds are only likely to face only a modest downside from prospective impacts of shortages on credit fundamentals, but some advantages can be gained from careful industry weighting and credit selection.
Junk bonds advantages and disadvantages
As with any other investment vehicle, investing in junk bonds comes with some pros and cons. The advantages include the following:
- Higher yields: Junk bonds generally offer higher yields than investment-grade counterparts. But in actual practice, the gain over investment-grade bonds may not be that much because there will be more defaults.
- Higher expected returns: There is a potential for significant price increases should the company’s financial situation improve.
- A signal for market risk: To some investors, an increase in buying interest of junk bonds serves as a market-risk indicator. If investors are buying junk bonds, it means that market participants are willing to take on more risk due to a perceived improving economy. On the other hand, if junk bonds are selling off with prices falling, it means that investors are more risk averse and are opting for more secure and stable investments.
There are also many disadvantages to investing in high-yield bonds. The disadvantages of high-yield bonds are as follows:
- High default risk: Junk bonds have a high risk of default. The possibility of default makes individual bonds too risky in the high-yield bond market. You may want to avoid buying individual junk bonds directly due to the high default risk. It is better to go for junk bond ETFs and mutual funds if you want exposure in the junk bonds category.
- Higher volatility: Junk bond prices tend to be much more volatile than their investment-grade counterparts, and their volatility tends to follow the stock market more closely than the investment-grade bond market.
- Higher interest rate risk: Another disadvantage of investing in junk bonds is that yields get eroded when there is a weak economy and rising interest rates. As interest rates go up, bond prices will go down. Although junk bonds are less sensitive to short-term rates, they closely follow long-term interest rates.
How to buy junk bonds – An Example
If you are looking for how to make money with junk bonds, you may first have to make your junk bond list. Buying junk bonds is like buying stocks: you choose the ones you want to buy and place your order via your broker if it’s a full-service brokerage. Many full-serve brokers participate in a secondary bond market to buy or sell bonds on behalf of their clients and to also access new bond issuances.
Note that a bond listing in the secondary bond market might look like this: Tesla Bond 8.625% 2/15/2028. As you can see, the first thing is the name of the organization that issued the debt, followed by the coupon rate (which shows a percentage of the face value of the bond at maturity). The last item is the maturity date, which shows when the investors will be repaid their capital.
If you consider buying individual junk bonds very risky, you may consider buying junk bond ETFs and mutual funds. They are usually considered better choices for retail investors interested in the high yields that such bonds offer. Junk bond mutual funds and exchange-traded funds (ETFs) allow you to benefit from the higher yields without the undue risk of investing in one junk bond that defaults. An example is the iShares iBoxx $ High Yield Corporate Bond ETF (HYG).
List of junk bonds
|Junk ETF List – Name
|The VanEck Market Vectors Fallen Angel High Yield Bond ETF
|The Invesco BulletShares 2024 High Yield Corporate Bond ETF
|The iShares J.P. Morgan EM High Yield Bond ETF
|The iShares Fallen Angels USD Bond ETF
|Fidelity High Yield Factor ETF
|Franklin High Yield Corporate ETF
|The Goldman Sachs Access High Yield Corporate Bond ETF
|The iShares US & Intl High Yield Corp Bond ETF
|iShares BB Rated Corporate Bond ETF
|The iShares High Yield Bond Factor ETF
|Xtrackers Low Beta High Yield Bond ETF
|The VanEck Vectors Emerging Markets High Yield Bond ETF
|The iShares iBoxx $ High Yield Corporate Bond ETF
|The ProShares High Yield-Interest Rate Hedged ETF
|FlexShares High Yield Value-Scored US Bond Index Fund
|The Xtrackers USD High Yield Corporate Bond ETF
|The High Yield ETF
|The First Trust Tactical High Yield ETF
|The IQ S&P High Yield Low-Volatility Bond ETF
|The PIMCO 0-5 Year High Yield Corporate Bond Index ETF
|The iShares ESG Advanced High Yield Corporate Bond ETF
|The iShares International High Yield Bond ETF
|The WisdomTree Interest Rate Hedged High Yield Bond Fund
|The SPDR Bloomberg Barclays High Yield Bond ETF
|The JPMorgan High Yield Research Enhanced ETF
|The Invesco Global Short Term High Yield Bond ETF
|The Invesco Fundamental High Yield Corporate Bond ETF
|Pacer Trendpilot US Bond ETF
|The iShares 0-5 Year High Yield Corporate Bond ETF
|The ProShares Short High Yield ETF
|The SPDR Bloomberg Barclays Short Term High Yield Bond ETF
|SPDR Portfolio High Yield Bond ETF
|The ProShares Ultra High Yield ETF
|iShares Broad USD High Yield Corporate Bond ETF
|WisdomTree U.S. High Yield Corporate Bond Fund
Junk bonds trading strategies – ending remarks
Please be aware that the junk bond strategies presented in this article might yield different results depending on the instrument you are testing on. For example, HYG owns junk bonds that are different from those of JNK and Fidelity’s VWEHX.
Nevertheless, we believe that by adding some junk bond trading strategies, you can improve your trading because they will most likely add diversification to your portfolio.
Why are junk bonds called “junk,” and what factors determine their risk level?
Junk bonds are labeled “junk” because of their higher risk of default. Factors such as credit ratings below BBB and Baa, issued by agencies like Moody’s and Fitch, indicate increased default risk. The risk is influenced by overall interest rates, market sentiment, and the financial health of the issuing company.
What historical performance do junk bonds exhibit compared to stocks, and how do interest rates impact them?
Despite being riskier, junk bonds have kept pace with stocks since the early 1980s, with lower volatility. Falling interest rates have contributed to higher junk bond prices and lower yields. However, the impact of rising rates remains uncertain, and past performance is not indicative of future results.
Is there a Turnaround Tuesday effect in junk bonds, similar to the stock market?
Trend-following strategies in junk bonds have shown promise, outperforming buy and hold. A sample strategy with a CAGR of 9.6%, low drawdowns, and positive returns suggests potential viability. Yes, there appears to be a Turnaround Tuesday effect in junk bonds, though not as distinct as in the stock market. The strategy involves buying at the close on Monday and selling at the close on Tuesday.
How do junk bonds work?
Junk bonds function similarly to regular corporate bonds, representing debt issued by a firm with the promise to pay interest and return the principal at maturity. The key difference is their lower credit rating, resulting in higher risk and, consequently, higher interest rates to compensate investors.
How are junk bonds rated?
Junk bonds are typically rated Ba1/BB+ and lower by credit rating agencies like Moody’s, Standard & Poor’s, and Fitch. These agencies evaluate the issuer’s financial health, assigning ratings that indicate the credit quality of the bonds.