Junk Bonds Flash Warning Signs for Stocks, Economy

Trouble is brewing for the economy and stock market. That’s the message that is being sent by junk bonds. For several months, the market for so-called high-yield bonds has been on the decline. In mid December, ahead of the Federal Reserve’s interest rate announcement, junk bonds tanked to their lowest levels in six years.

Amidst the rout, one major mutual fund company (Third Avenue Management) froze withdrawals from one of its large credit funds. Some hedge funds that specialize in distressed debt are also suspending redemptions. This batten-down-the-hatches mentality echoes what happened in 2008. Will another major financial crisis usher in the New Year?

Investing Icon Warns a Meltdown Is Beginning

The smart money is growing increasingly concerned about the broader implications of the junk bond hiccup. Billionaire investor Carl Icahn warned that a “meltdown” is “just beginning.”

For conservative investors, the message of the junk bond market is that it’s time to get defensive. The stock market is now vulnerable to a sharp and protracted sell-off that could potentially wipe out years of gains. That’s what’s happened to junk bonds, and they are potentially a leading indicator.

For aggressive contrarian investors, the junk bond rout represents an opportunity. Yields have shot up in the “sub-prime” credit market, meaning you now stand to be rewarded for taking investment risk. A year ago, when the yields on high-yield bonds weren’t so high, the risk-reward balance was tilted more heavily toward risk. Holders of these high-risk instruments have since found that out the hard way.

Bottom Fishing Risks and Opportunities

If you are thinking of entering the junk bond market in hopes of buying at a bottom, you may have the opportunity to do so at some point in 2016. We’ll only know in retrospect when the market has hit bottom. In the meantime, if you want to enter this volatile market, prudence dictates that you do so gradually and with caution.

Avoid low-liquidity funds. The largest, most liquid high-yield fund is iShares iBoxx High Yield Corporate Bond (HYG). With more than $15 billion in assets, it’s not likely to be delisted anytime soon. And since it’s exchange-traded, you can get out at any time by selling into the market. You don’t have to worry about seeking a redemption directly from the fund manager.

You do have to worry about the credit risk of the underlying assets, though. Defaults could shoot up if a deteriorating economy creates a cashflow crunch for financially troubled companies.

But in a world of low yields on conventional bonds, a basket of high-yield bonds could outperform over time.