Investing in Junk Bonds – Part 1

When to be in the Junk Bond market and When to be out

junk bond market 1By Author of Life, Investments, Everything Blog

Especially in an environment of historically low interest rates (1% on a 5 year CD anyone?), many investors are tempted to chase yield in any corner they can find it.  If you have been accustomed to receiving 4 to 6% interest on a long term CD or bond and the investment matures today you are faced with a real problem, especially if you have been living on the interest.

The owners of such maturing investments essentially have three choices:

  • Accept current low interest rates on low risk instruments like US treasury bonds, CDs, and the like
  •  Attempt to earn higher yields by taking on more risk with junk bonds, preferred stocks, and the like
  • Buy an annuity from an insurance company with the proceeds of the CD or bond that just matured (probably only a feasible strategy at ages 65 and up).

With more and more people faced with this quandary as time rolls on and low interest rates continue with no end in sight, it is important to understand the risks and opportunities presented by the junk bond market before you give in to the temptation (or necessity) of yield-chasing.

According to the Securities Industry and Financial Markets Association (SIFMA), total outstanding US bonds (including corporate, municipals, treasuries, agencies, mortgage bonds and asset backed securities) amounted to about $32.3 trillion as of the second quarter of 2011.  Of that total, approximately $1.4 trillion or about 4% of the corporate bond market consists of junk bonds, also known as high yield bonds.  It is worth noting that the junk market is far smaller than the investment grade corporate or treasury markets.  Also important is the fact that there are far fewer large investors in junk bonds, as many pension funds, financial institutions, mutual funds and other vehicles are either heavily restricted in how much junk debt they can own or entirely prohibited from knowingly purchasing junk.  Junk-rated companies which issue bonds also tend to be smaller issuers than investment grade companies (their frequently smaller size is often a primary reason for their low credit rating), which means that the bonds they issue are typically far less liquid than those of investment grade companies.  The combination of relatively small market size and relatively few large players (mostly hedge funds and mutual funds) means that the junk bond market is a lot less efficient than “mainstream” parts of the bond market and is much more subject to significant price swings as relatively few large players buy or sell.  Of course, the relatively few players in this market also means that there are times of valuation extremes, both high and low.

The large swings in valuation are most easily observed through the Barclays Capital High Yield Index (or the index of your choice) depicting option adjusted spread over treasuries for the index:

Barclays Capital High Yield Index Chart

Barclays Capital High Yield Index Chart

What the above chart shows us is that spreads over the past 5 years ranged from around 3% to almost 20% (!) above treasuries.  Since junk bonds typically have adjusted durations of about 4 to 5 years, these changes in spreads can cause very large changes in the market value of the bonds (a 5% change in the rate of a bond with 5 year duration will result in between a 20 and 25% change in the value of the bond).  So as spreads move up and down with the considerable volatility this market contains, values of junk bonds can fluctuate wildly.

 

In addition to market value fluctuations, junk bond investors have to concern themselves with defaults and the permanent losses of capital that come with them.  Not surprisingly given the big swings in spreads/market values, defaults also exhibit quite substantial volatility.  On average over the last three decades, 3 to 4% of the junk bonds outstanding default every year.  If you are getting an extra 5% yield and a default means you lose perhaps 70% of the par amount on average (for an average credit loss of .7 X 4% = 2.8%), this does not sound so bad, right?  The problem is that we do not live in a world of “average” every single year.  In the past 20 years there have been 3 or 4 years (depending on which source you believe) where over 10% of the bonds outstanding defaulted.  So the time of your purchase matters quite a lot in the junk world, very much like it does in the equity market.  Junk also tends to have significant correlation with the equity market, as both junk bonds and equities are sensitive to economic conditions.

Scared yet?  If you are looking at junk while holding onto your maturing CD proceeds, you should be.  But not all investors should run screaming from the junk market at all times.  The history of the junk market suggests that there are 3 states of the junk market:

  • “Shooting fish in a barrel:” Spreads are at historically high levels and have priced in Armageddon, so one can blindly buy the whole market with a high probability of earning excess returns as the market normalizes and spreads decline within a year or two.
  •  “Run away:” Spreads are at excessively low levels, investors have gotten stupid with junk, and you will probably be sorry if you buy now.
  •  “Hunt and peck:” Spreads are neither historically high or foolishly low.  A modest allocation to junk is probably OK, but the best results will probably be achieved by owning the relatively “clean” credits in this market (BB rated) or by picking specific bonds so as to avoid the clunkers.

You might ask how we tell which of these three stages the junk market is in at any given time.  If your crystal ball can forecast the start and end of recessions with at least 6 months of advance notice, you are all set.  Those of us without accurate crystal balls must instead look to the relative value of junk pricing compared to history.  The easiest stage to identify is the “run away” stage.  When spreads are 5% or less over treasuries, the junk market is not attractive and you will probably be sorry you bought.  Other signs that we are in the “run away” stage include high volumes of new junk bonds being issued and press reports of increasingly relaxed covenants, pay-in-kind bonds (option ARMs for junk-rated companies), and the like.  The “shoot fish in a barrel” stage is slightly harder to determine.  Historically, spreads in excess of 7.5% would have put you in this territory with a reasonable amount of certainty.  However, anyone following this rule would have bought junk in the second half of 2008 only to see the junk market implode over the next year.  So you either have to wait for in excess of 10% spreads or hope that the near-collapse of the financial system was a once in a lifetime event and stick to the 7.5% cutoff.  Once you have determined where you think the high and the low stage boundaries are, everything else is in the “hunt and peck” middle ground.  Based on the chart above, the junk market appears to be on the cheap end of the “hunt and peck” range.

So if you are thinking about chasing yield in the junk market, pay close attention to how the market is priced and where spreads are in relation to history.  Simply buying and holding junk is likely to leave you with little excess return over treasuries and with a lot more sleepless nights than going to the local bank and buying a CD.  Caveat emptor, and remember that while history is our best (and only available) guide to the future, it is not a perfect guide by a long shot.

In the next installment I will detail how I evaluate individual junk bonds.

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Comments

  1. Gerelmaa says

    Yes, if government bond yldeis rise as credit spreads tighten, then the two effects could cancel eachother out. Or worse, if government bond yldeis rise faster than credit spreads tighten, the bond yield would rise. Due to our fears about the potential for government bond yldeis to rise, we ve sold government bond futures in our investment grade corporate bond funds to hedge against this risk.You re right about it only being the large investment grade companies that have easy access to finance right now yldeis on sub-investment grade bond issuers are still significantly above historical average, which is a reflection of the difficulties that some of these companies face in terms of refinancing. And you re idea definitely makes sense another department in M&G s fixed income team has done exactly that (see ) note, however, that it would be tricky doing this in the retail space since the underlying holdings need a greater degree of liquidity

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