Four Reasons Why Junk Bonds Might Be Worth Buying

High-yield bonds, also known as junk bonds, have a lower credit rating than investment-grade bonds because they carry a higher risk of default. To compensate investors for that increased risk, junk bonds pay a higher yield.

Last year, however, was painful for those who bet on these securities.

SPDR Bloomberg High Yield Bond

(JNK), an exchange-traded fund that holds a basket of junk bonds, had a return of minus 12.2% in 2022, according to Morningstar Direct. The drop followed three consecutive years of annual gains of between 4.3% and 15%.

“The total return was driven by rate increases,” says

Sonali Pier,

a portfolio manager at Pimco in Newport Beach, Calif. The bond price is determined in large part by two factors: the interest rates the government pays to borrow money, plus the credit spread, which is an additional cost that depends on the borrower’s creditworthiness. In this case, the spread increase was far lower than the rise in government borrowing costs.

When interest rates rise, the price of the bond declines. It works vice versa as well. With junk bonds, there is the added fear that higher rates could spark an economic slowdown that might increase the likelihood of borrower defaults.

While last year was all about the Fed for junk-bond investors, this year looks different, analysts say. Already the subsector is off to a good start, with the SPDR Bloomberg High Yield Bond ETF up 3.2% this year through April 5.

Here are four reasons high-yield investments could a produce a positive return this year, and maybe even a rally.

1. Historical returns

Going back to 1987, the Bank of America US High Yield Index, which tracks a basket of junk bonds, has never suffered two consecutive years of negative returns. That includes the years of the global financial crisis of 2007 to 2009.

The reason for this historical pattern may be in part technical. When bond prices fall, as they did in 2022, yields rise. Last year began with junk yields at 3.5%. By the end of the year, they were twice as high at 7.1%, according to the Federal Reserve database. With yields that high, bond prices would have to fall more than 7% for junk-bond investments to produce a negative return, which experts say is possible but unlikely.

“At today’s yield levels, there is now a cost to not being invested,” says Ms. Pier.

2. Healthier borrowers

The companies issuing high-yield debt these days are in better shape financially than they have been in the past, according to analysts. “There are fewer issuers, and they are large and generally have more avenues for raising money if they need it,” Mr. Tchir says.

That is partly because many wobbly borrowers have migrated away from issuing junk bonds to borrowing in the loan market, where business loans are packaged and sold to investors in much the same way mortgages are. Lenders in this market have increasingly adopted “covenant-light” contracts, meaning they demand fewer conditions and safeguards from borrowers, Mr. Tchir says. While that’s good for borrowers, investors may be far more exposed to risky borrowers when betting on loans versus junk bonds.

3. Underrated bonds

Many of the remaining borrowers in the junk-bond market are larger companies with robust balance sheets and decent financials. Yet their bonds continue to be labeled as being at a higher risk of default.

That’s because credit-rating firms have become much more cautious about raising their ratings, due to some classification mistakes made in the past. As a result, some bonds that would have been designated as investment grade no longer are.

The good news for junk-bond investors is that underrated companies are less likely to default on bond payments than their rating might suggest. And fewer defaults typically mean less pressure on junk-bond prices.

“Rating agencies are reluctant to move securities into investment grade,” Mr. Tchir says. “Their bias seems to be to underrate bonds.”

4. Economy’s direction

Many analysts believe the economy will slow or enter a mild recession later this year. If or when the economy slumps, two things will happen to change the price of bonds. First, yields on 5-year Treasurys will start falling and may hit 2% by mid-2024, down from 3.4% recently, according to Matt Mish, head of credit strategy at

UBS

in New York. Similar to other longer-dated Treasurys, the yields on 5-year Treasury notes tend to fall during recessions, reflecting slower economic growth and lower inflation, something that some analysts predict could happen later this year or in early 2023.

Since most junk debt is tied to the yield on the 5-year Treasury note, the lower interest rates will lift bond prices.

However, the benefit of falling government rates will be partially offset by increases in junk credit spreads of approximately half a percentage point by the end of the year, according to recent UBS research. As such, Mr. Mish sees total returns for junk bonds of around 7% for the year, which takes into account possible defaults by some borrowers.

Of course, not everyone is so optimistic. In the event of a sharp economic recession, this type of investment could get hurt, says Bill Merz, head of capital markets research at U.S. Bank Wealth Management in Minneapolis. He points to problems with economic growth, stubborn inflation, liquidity issues and government policy. Slower economic growth would put greater financial stress on junk-rated companies than on others, which could lead to increased levels of defaults on high-yield bonds.

“If macro headwinds come to fruition, there’s a chance we have another challenging year for high yield,” he says.

Mr. Constable is a writer in the Occitanie region of France. He can be reached at reports@wsj.com.