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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

spdr-barclays

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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Adam Aloisi

Adam 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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