A Contrarian View Of High Yield Bonds

high yield bondsJuly was not the month to be buying high-yield debt. With major indexes HYG and JNK dropping by about 4% each, bond investors were in a rush for the exits on higher than average volume, especially during the past week. The move comes on the heels of a mild yield spike in Treasuries. Should you look at this weakness as a buy opportunity?

  To see a list of high yielding CDs go here.  

I’ll start by talking about some of the well documented and rehashed reasons why you should not buy high yield bonds. Interest rates are low, spreads (difference between yields on junk credit and investment grade bonds/Treasuries) are very narrow, and junk debt just doesn’t present a compelling opportunity. Basically you are identified as a yield chaser if you are looking at high-yield bonds in today’s market.
JNK – 3 months

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But these arguments have been around for years. While yields have been ever so slowly moving lower, the opportunity cost for sitting on the sideline in cash has been relatively high as all bonds, high-yield included, continue to pay their variable coupons while cash earns next to nothing. Though I’m not saying that a higher rate environment is not necessarily going to be upon us going forward, I am saying that the average bond investor has not been well served by listening to perpetuating bearish or “bubblish” calls. The constant admonition to avoid bonds has been flat-out wrong

For many investors, junk debt, given its general attributes, indeed does not make a lot of sense, low rate environment or not. Of course high-yield debt is a rather large universe, ranging from BB+ (S&P), which is one notch below investment grade all the way down 9-notches to C, which means a bond is in imminent risk of default. On a credit level, I would be the first to urge caution on ALL ‘C ‘- rated securities, but as we climb the credit quality scale, we run into household variety companies. Names like retailer Limited Brands (Victoria’s Secret, Bath & Body Works), electricity supplier PPL Corp. and homebuilder Toll Brothers are all BB+ companies that fall into the upper end of junk debt.

Individual bond investors, and to a lesser extent bond fund investors, can control their risk both on a credit level and on a maturity level. While I continue to urge caution on duration risks, I feel the constant admonition to avoid bonds has scared away a large constituency that could benefit from the portfolio diversification and cash flow benefits that bonds offer.

So I take a different view towards high-yield. When one buys a high-yield bond or any bond for that matter, they accept an agreed upon rate of return over a specified time period. If the yield/return is perceived as too small, then the investor should pass on the opportunity and look elsewhere. If the yield/return is acceptable over the specified period, then the investor should not fret if the rate environment changes. The average investor is best served by buying an issue, monitoring the credit quality on occasion, but not obsessing over market valuation. The monitoring issue does become more important as credit risk escalates, so the BB bond investor, in general, can probably can be a bit more lackadaisical than the B bond investor.

So when we look at some of the offerings available in BB+ land, I see paper from PPL Energy Supply yielding 5.5% over 7 years. I see CenturyLink paper of about 8 years for 5.3% and I see 5% Toll Brothers 10-year paper for 5 percent. Not gigantic yield, but still substantial when compared to cash at zero and 10-year Treasuries at 2.5 percent. As we slide down the credit chain, risks become more apparent, and yields climb a bit.

As I’ve opined in the past, as one slides down the credit scale, the more point to perhaps utilizing pooled products (funds) as your investment weapon of choice, given the immediate, robust diversification benefits. Today, you can get a nearly 9% yield in Prudential Short-Duration High-Yield (GHY) which now trades at an 8% discount to NAV. While an additional layer of risk through leverage is added on here, it holds almost entirely B-rated paper. Again, not for everyone, but an aggressive thought for the investor in search of robust yields.

To conclude, for many years now the media, market pundits, and many uniformed equity strategists have been negligently urging investors to avoid bonds. As part of a diversified investment program, bonds and higher grade high-yield bonds provide portfolio balance and durable cash flow streams. While I’m still not going to say that rates will not rise over the intermediate-term, with equity markets becoming ever so frothy, a predictable coupon payment, even a low one, could start to look much more attractive than a declining stock price.

About the author:

aloisiAdam Aloisi has over two decades of experience investing in equities, bonds, and real estate. He has worked as an analyst/journalist with SageOnline Inc., Multex.com, and Reuters and has been a contributor to SeekingAlpha for better than two years. He resides in Pennsylvania with his wife and two children. In his free time you may find him discussing politics, playing golf, browsing antique shops, or traveling.

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Comments

  1. says

    Mr. Aloisi, thank you for sharing your helpful comments.in a very nice article. I am an individual retiree seeking preservation of capital and wanting to grasp income on limited savings. You do touch very accurately upon the fear that keeps most retirees on the sidelines sitting on idle non productive cash.

    Are there any numbers or facts available where junk Bond ETFs or Mutual funds have failed disastrously for being terribly stupid and totally careless ? Is it true that in recent years junk bonds have defaulted to the tune of less than 5 % ?

    If the above is true, then the risk of investing in junk bond ETFs or mutual funds is really no more than investing in equities that jump up and down in price all the time. In other words these ETFs that cater to juk bonds are in many ways like typical equities, with the added worry of interest rates.

    Would you agree with the above observations ?

    • says

      MKY….First, thanks for the question. The two largest high yield bond index funds – HYG and JNK took 40% haircuts for a time during the financial crisis 5 years ago – and have not bounced back, at least on a price level back to where they were prior. While I’d like to say that the crisis will be a once-in-a-lifetime event, no one can know for sure. High yield defaults, while you are correct to say are in the very low single digits today, did spike to the low teens five years ago as the crisis developed and eased.

      Today you are not rewarded highly for investing in ETFs, as the yield is in the 5.5-5.75 range. If you go out on the duration scale you can find investment grade bonds (BBB) yielding that much. If you are looking at a pooled product, I would encourage you to look at CEFs, which are yielding more and you can find a few that don’t employ leverage, unlike GHY which I mentioned in the article.

      As a retiree you want to be as conservative as possible to make ends meet. You have risks in both equities and high-yield bonds, but they are different, so it is very difficult to say that the “risk” is equal or even similar. We can say with ease that the risk of both is greater than cash. Bond risk is in credit and duration primarily, whereas stock risk is typically related to underlying earnings and the general supply and demand for the stock.

      So where you invest is a mix of risk tolerance, income need, and forward perception (rather than over analyzing the past). Since no one knows for certain where things are headed, the safest portfolios, in my opinion, own a mix of assets to hedge against the unknown. As a retiree, you should think long and hard about each investment and whether risk being taken is commensurate with what you think the reward will be.

      Hope that answers your question.
      Regards, Adam

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