Tough Times for High Yield Securities

High yield sectors have had a truly outstanding year in 2009. Junk (high yield) bond funds are up over 50%, from a time when their yields were at record levels (above 25%). Back then, risk was being punished, and risk aversion became the driving force for investors. The subsequent rally has reduced yields from dividends paid by junk bond funds to 10-12%, not too far above the 9% area they have yielded in the best of times.

Last week, Bill Gross, head of PIMCO, the world's largest owner of debt, said junk bonds had peaked. Junk bond funds sold off but have bounced back partially this week.

The Dow Jones REIT Index plunged from the 250s prior to the financial crisis last year to 82 early this year. When the financial crisis hit full force, some REITs were forced to cut or eliminate dividends under financial pressure, including the largest REIT: Simon Property (SPG). Then, REITs had a strong recovery around midyear. After more than doubling from their lows, REIT gains have been limited by choppy trading in the last three months. The index has waffled around 160 or 10% below its peak six weeks ago. Worries are growing that vacancy rates on properties will rise if economic recovery is slow.

MLPs suffered a similar decline. The Alerian MLP Index had already fallen to 270 by September of last year, then it plunged below 155 (a 6-year low) in the extreme market sell-off. Early this year, the yield on the index soared to over 15% (never seen before). Since then, MLPs have rallied, with many doubling from depressed levels. Their businesses continue strong, moving more oil and gas through pipelines. MLPs have not had trouble selling more equity units and borrowing more money. Raising capital is critical for their their investment programs, pipelines and terminals. They have just announced Q3 earnings and distributions for Q4. Many of their distributions showed quarter over quarter distribution increases.

While near their yearly highs, high yield securities are feeling selling pressures after their best year in history. Their future is tied to a rapidly improving economy. Greater concerns about a sluggish rebound are encouraging successful investors to take some money off the table. A faster recovery will solve many problems associated with high yield securities, while stretching out the recovery will aggravate problems -- higher default rates on junk bonds, higher vacancy rates on properties, etc. I worry that high unemployment rates (including under-employed workers) and soggy levels for housing, autos and retail sales into 2010 will bring higher yields and correspondingly lower prices for these securities.

Disclosure: Long SPG

Comments

[iel76:]

The game in high yield has as much to do with risk spreads as it does to underlying rates. Where were spreads pre-crash, how much spreads expanded in the panic, where spreads are today and where might they be if the economy does continue to show recovery. Without discussing risk spreads, you have no business discussing the direction of junk bond prices.

Nov 05 07:20 PM

[aussiereader4:]

I guess the yield suggests the market thinks a third will fail. I wonder which third?

Nov 06 02:12 AM