Everyone May Be Junk Bond Investors, Whether They Know It or Not

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When most bond investors invest, they probably think of Treasury bonds, government agency bonds or high-grade corporate bonds. Just hearing the terms “junk bonds” or “speculative grade” bonds might make some people squeamish when it comes to the safety of their assets. Still, some investors flock to the junk and speculative bonds.

It turns out that the investing community may have no choice but to own junk-rated and speculative bonds.

24/7 Wall St. routinely reviews the makeup of the investment grade market and the speculative grade debt markets. Standard & Poor’s most recently showed that the speculative-grade composite spread was 527 basis points, meaning that the yields across all maturities on the curve came to an average yield of 5.27% higher than their respective Treasury yield.

So, how is that every investor out there who invests in bonds is likely a holder of junk bonds? Recall that ratings under BBB- (those rated BB+ and lower) make up the junk bond universe.

S&P sent out a note showing that the investment-grade companies (again, those rated BBB- and higher) as a total share of U.S. companies have gradually declined over the past several years. They also show that speculative-grade issuers (again, those rated BB+ and lower) have been the majority of U.S. corporate ratings since 2010.

S&P also showed that the majority of companies that comprise the S&P 500 Index are predominately rated investment grade and their debt is largely investment grade. They showed that 94% of the total index weighting is rated BBB- or higher.

Still, the majority of debt issued by companies is not just S&P 500 companies. The S&P 500 Bond Index tracks the performance of rated debt instruments with nearly $4.3 trillion in market value. It was shown that the equity market caps of the S&P 500 Index is roughly 80% of the  market capitalization of the total available U.S. stock market, but the S&P 500 Bond Index represents almost 60% of the value of U.S. corporate bonds that are currently rated by S&P Global Ratings.

All in all, that means, assuming the 6% that are not investment grade, that 40% of all U.S. corporate debt is junk-bond issued by market value.

If you add up all the debt, including non-corporate debt, over 90% of the rated bond index is investment grade by weighting, but just 45% of U.S. corporate issuer ratings are currently investment grade (or 81% of U.S. corporate bonds). S&P further said:

Companies with stable rating outlooks issued 80% of the debt included in the rated bond index, and just 15% of the debt in the rated bond index is from companies with negative rating outlooks or ratings on CreditWatch with negative implications.

The reality is that there is a wild card to this equation that makes the tally of corporate ratings almost irrelevant and will show why most bond investors are likely to own junk bonds. Most bond fund managers who manage funds outside of exchange traded funds (ETFs), meaning in closed-end and open-end mutual funds (or in private accounts), actually have the leeway to invest in debt that is not actually investment grade.

The percentage of the total weighting that has “exceptions to being investment grade” can vary greatly from bond fund to bond fund. Some junk-ratings may be held because they are close to maturity, but some may be held because the fund manager feels the risk-reward is better than the formal ratings or that the ratings will become investment grade ahead.

S&P itself didn’t come out and say that most investment-grade bond funds will hold junk-rated bonds. That is something that you will know if you have dug through various dull bond prospectus readings over the years.

Whether or not bond fund investors know it, they probably directly or indirectly own junk bonds.