Off the Charts: Junk Bonds Gain Popularity Even as Yield Falls

During the first quarter of this year, a record $133 billion of such bonds were sold around the world. While sales in the United States fell a little short of the record set in the third quarter of last year, that was more than made up for by rising sales in Europe and Asia.

At the same time, the yield on such bonds has fallen to the lowest level on record. The Bank of America Merrill Lynch U.S. High Yield index yielded 5.7 percent at the end of the quarter, as can be seen in the accompanying graph. That was down from 6.1 percent at the end of the year, and from 8.3 percent at the end of 2011. Junk bonds are those rated below investment grade by the bond rating agencies, and their current popularity reflects the search for yield by many investors, whose alternatives include savings accounts that pay almost nothing.

To some, that is cause for concern. In a speech to the Economic Club of New York last week, William C. Dudley, the president of the Federal Reserve Bank of New York, pointed to “potential excesses in certain corners of the financial markets,” saying the high-yield market and the related leveraged loan market “do seem somewhat frothy.”

He added, however, that even if those markets were to incur major setbacks, the overall economy might not be badly affected. “The size of the asset classes in question is relatively modest, and most of the investors in these assets are not highly leveraged,” he said. “So if asset valuations were to adjust sharply and some investors experienced painful losses, I do not expect that such a shock would threaten financial stability.”

Since the last century, high-yield bonds have generally done better than stocks in good markets, and better than stocks in bad markets as well. In 2008, the Merrill Lynch high-yield index fell 26 percent, while the total return of the Standard Poor’s 500 stock index was a negative 37 percent. And when recovery came, the bonds rose more. In 2009, the bond index leapt more than 57 percent, well over the return of more than 26 percent on an investment in stocks. But that advantage has disappeared this year. In the first quarter, the bond index returned 2.9 percent — including capital gains from rising prices and the interest received on the bonds. But the S. P. 500, including reinvested dividends, rose 10.6 percent.

Martin Fridson, the chief executive of FridsonVision, a research firm, notes that the spread between Treasuries and junk bonds has fallen for three consecutive quarters. He says it is unlikely that will continue, and forecasts that spreads will widen in the current quarter. If so, investors in high-yield bonds could lose money as prices decline.

The perceived frothiness of the high-yield market would seem to be illustrated by the relatively low difference — or spread — between the yields on junk bonds and on United States Treasuries. At the end of the first quarter, it was 4.86 percentage points, well below the historical average.

Moreover, the yield on Merrill Lynch’s index of lowest-quality junk bonds — those rated CCC plus or lower by Standard Poor’s — is 9.3 percent, only a few basis points higher than the record low set in spring 2007, as credit markets were about to fall. But Treasury rates were much higher then, so the level of speculation would seem to be much lower.

Mr. Fridson also noted that nearly a third of the companies that issued high-yield bonds for the first time in 2012 were among the lowest-quality borrowers. “When high-yield managers are under pressure to invest large cash inflows, as they were last year, and when high-yield issuers feel no particular pressure to borrow, the financing window may open to lower-quality credits that would be excluded under other circumstances,” he wrote in a commentary published by Standard Poor’s Leveraged Commentary and Data.

Floyd Norris comments on finance and the economy at nytimes.com/economix.

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