Junk Bond Funds in Q2: Large Bumps Ahead

Stocks have had one of their best rallies ever during the last 7 weeks as risk and caution have been thrown to the wind by buyers. Many low priced stocks have more than doubled. The best example is Citigroup (C): it's hard to believe that it's still in the Dow. The stock had plummeted to only 1, a price which could not have been imagined last year. In the market rebound, it recovered to the 4s before settling back to 3.20

The Barclays Capital High Yield Bond ETF (JNK) tracks the junk bond market. It started 2009 at 31 but fell to 26 in the market sell-off early in the year. In recent weeks it has recovered to 32 while the yield has fallen to 17%.

Individual junk bond funds have had more extreme price swings. Tolerance for risk has changed, investors will accept more risk when going after very high yields. In early 2009, the VIX (volatility index), reached a high of 55. It was 50 near the low of the stock market and has fallen to the mid 30s presently. Risk is tolerated better than a few months ago. Greater risk tolerance applies to stocks (especially low priced, very risky stocks) and high yield securities.

The future is not as rosy as the runup suggests. I like junk bond funds and continue to be attracted to their extraordinary yields. The spread above the 10 year Treasury bond yield is 1600 basis points. But junk bonds haven't hit the rough patch which is coming. Other high yield businesses have been preparing for stormy weather. REITs have been lining up finances and extending maturities on debt to help them through difficult times. Already rental income is falling as evidenced by empty store and apartment for rent signs going up. MLPs are also extending loans and lining up additional financing.

Unfortunately for junk bonds, there is not much they can do to prepare for a higher default rate on loans other than pay down their own debt to limit future damage. But few have that courage plus it would mean selling junk bonds with extraordinary yields.

After the runup in junk bond funds, caution is needed. High yields are attractive but the unknown magnitude of bond defaults which will damage future dividend payments is unknown. Yields of 25% might have provided enough additional income to cover future dividend cuts from lower interest income. Present yields provide less cushion which will be needed, especially because of the use of leverage by junk bond funds to magnify fluctuations. When the economy gains strength, yields on junk bond funds should decline to 10% or less, implying significant capital gains. But that time looks far away while large bumps lie ahead.

Disclosure: No positions

Comments

[Elliot Eise...:]

This would be more helpful if you were to suggest a handful of widely held issues which are likely to default.

Apr 28 04:30 PM

[shootpar2001:]

You mean like the auto industry?
From the manufacturers to the suppliers and so forth.....
The housing industry and it's suppliers.....
To a few financials.....
Pick a diversified bond fund and collect payments.
With everyone except the gov't trying to pay down debt; get in line and collect payments.

Disclosurers: (ACG), (PTY), (MSY), (PSY).



On Apr 28 04:30 PM Elliot Eisenberg wrote:

> This would be more helpful if you were to suggest a handful of widely
> held issues which are likely to default.

Apr 29 10:41 AM

[Sicall:]

I would like someone to explain the risk on these "junk bond" ETF`s as it is not immediately obvious to me what it is.

As they are a Fund they do not act like a Bond so buying at a certain price does not lock you into a specific yield.

Also as the ETF tracks an index, they hold a large number of different Bonds therefore a default on one should not greatly affect the NAV or the dividend.

If i have got the above points right then the effect of defaults in an ETF such as JNK which has a holding of 100+ bonds is small. Another factor is as the defaults are not widely publicised how do you know how many of JNK`s holdings have defaulted?

May 01 08:11 PM