Junk Bonds Roar Ahead

We are approaching the one year anniversary of the market meltdown last September. Since then junk bonds have gone through an unforgettable 12 months. After plummeting during the first two months, junk bonds have roared back in 2009. Many funds have recovered their market values from the start of the market meltdown, although reinvested dividends have been a big help. They rode the cycle from risk averse to risk acceptance in today's markets.

Junk bond yields carry higher because their lower quality ratings relate to higher risk for future interest payments. In the best of times, their yields are near 9% with a spread over the 10 year Treasury bond yield around 450-500 basis points. Early this year, the yield on junk bonds shot up to 20-25% with a yield spread of more than 2000 basis points (levels never seen before). Risk averse was the driving force in financial markets. Stocks and high yield bonds were sold recklessly to reinvest proceeds in safe investments: Treasuries, gold, etc. With the subsequent rise in the markets, yields plummeted to today's values which approach traditional levels.

For optimists who believe in a quick recovery for the economy, high yields on junk bonds will be tempting. 12-13% sounds great. However, default rates on bonds are up this year causing almost half of junk bond funds to reduce dividends. So far, default rates have not reached exceptional levels feared. The major obstacle is the risk of high levels of defaults continuing or growing.

Important in assessing their future is the allocation of investment portfolios. Money invested more wisely is going to have fewer defaults (i.e invested in better preforming industries). Most junk funds use leverage to earn more money for stockholders. They borrow against assets with the hope that positive carry (interest income greater than interest expense) will add to earnings for the stockholders. In good times the concept works great but in bad times it works against stockholders.

Optimistic investors will be more interested in funds with higher leverage. Junk bonds are really just stocks with very high yields, it's that simple. If stock markets continue to recover, junk bonds should rise in value which will reduce their yields. Those with less optimistic views of economic recovery will be content to "await developments" waiting for lower prices bringing higher yields.

Yesterday stock markets around the world sold off sharply on worries about a slower economic recovery. Risk averse was rediscovered by investors. Treasuries rose while MLPs, REITs and junk bond funds fell sharply. If risk averse takes over investment attitudes, present yields on junk bonds will prove low going forward.

Disclosure: no positions

Comments

[Hostwisely123:]

For businessmen who really made up their best in their business, they have to make sure that they are on the right track when doing their business, in such a way that they will be successful in their business.

Aug 18 01:01 PM

[MartySS:]

Huh?


On Aug 18 01:01 PM Hostwisely123 wrote:

> For businessmen who really made up their best in their business,
> they have to make sure that they are on the right track when doing
> their business, in such a way that they will be successful in their
> business.

Aug 18 10:02 PM

[46goat:]

Does this guy get paid by the word ? He didn't really say anything !
At the end of the article I'm left asking myself, "Why did I bother reading this ?".

Aug 19 12:59 PM

[macro -N- i...:]

This article is a good summary of all the articles and research I found. After the March low I bought into various bond categories,including high yield and emerging market. The nav's rose over the summer and I had monthly dividends. Mr. Morris is correct in that default rates and portfolio makeup are the key elements to focus on during research. I have sold with a smile and will rejoin after the correction.(At least I see one coming, the most I can lose now is a few months of dividends)

Aug 23 10:47 PM

[Dastoli:]

What has this to do with junk bonds?


On Aug 18 01:01 PM Hostwisely123 wrote:

> For businessmen who really made up their best in their business,
> they have to make sure that they are on the right track when doing
> their business, in such a way that they will be successful in their
> business.

Sep 09 10:04 AM

[Dastoli:]

What he said has no relation to junk bonds?

Sep 09 12:01 PM