Overreaction Creates Buy Opportunity in High-Yield Bond Funds

Includes: BND, DHF, PHT
by: Shane Lofgren

Bonds have been taking a beating lately and certainly not without reason. The economic data have been positive recently and the increase in liquidity from QE2 will certainly put pressure on inflation and thus interest rates.

However, it seems that while the current environment is negative overall for bonds and much of the decline has been a justified correction, investors are focusing overmuch on interest rate risk and ignoring a positive trend in credit risk. The same liquidity that creates inflation pressure also makes refinancing easier for shaky firms. Furthermore, interest rates will almost certainly not rise until there is a sustained recovery, which means that credit risk and interest rate risk will not rise at the same time.

This analysis is supported by a recent report from Moody's which, according to Bloomberg, found that

the global speculative-grade default rate fell to a two-year low of 3.3 percent last month... as junk-rated borrowers tapped the bond market at a record pace. The rate declined from 3.7 percent in October and 13.6 percent a year ago, Moody’s said in a report today. Defaults will fall to 2.9 percent by year-end and 1.8 percent by November 2011, according to the report.

So which bonds stand to be least hurt in this environment of rising interest rate risk and declining credit risk? High yield bonds. Yet, during this period where investors have been shunning bonds, high yield bond funds like PHT and DHF have fallen by 11.9% and 8.1% respectively while BND, an ETF that attempts to measure the whole bond market, has fallen by only 2.2%. Now, it's important to note that PHT and DHF use leverage and were trading at high premiums above NAV a month ago and much of the decline has been from that premium rather than from underlying NAV. However, I am still struck by the fact that the large decline might be an overreaction and that there might be a strong buying opportunity here.

To decide whether this is a deserved correction or an overreaction and thus a buying opportunity, we need to consider what the funds actually offer and how we can expect them to perform going forward.

As I've mentioned, interest rate risk is currently looming as the largest risks facing bonds. On this measure, PHT and DHF perform very well with an effective duration of 3.2 for PHT and 3.8 for DHF compared with 4.8 for BND. This is unsurprising since, if interest rates increase, high yield bonds will have to fall by less in value than lower yielding bonds in order to keep effective interest rates the same. What about credit risk? It's hard to assess, but assuming that Moody's is right about its projected default rate and the funds follow Moody's, then they should have defaults of 3.3% of their portfolio. Assuming the worst case scenario of zero return of principal in bankruptcy, then, multiplied through by the leverage ratios of 1.4 for DHF and 1.5 for PHT, they should lose 4.62% and 4.95% respectively off their NAV.

Thus, assuming a worst case scenario where there is a 100 bp increase in interest rates and they suffer defaults as mentioned above, PHT should lose 3.2% from interest rates plus 4.95% from defaults for a total of 8.15% while DHF should lose a total of 3.7% + 4.62% or 8.32%. That sounds pretty terrible, but we have to consider the benefits side of this cost benefit analysis.

After the current correction, the market yields on PHT and DHF stand at 11.38% and 12.4% respectively. Let's assume that the interest rate increases happened all at once and all at the end of 2011 (a near impossibility) so that they weren't able to spend the money from their maturing debt on higher yielding debt and thus increase their interest income. Let's also assume that the defaults we mentioned above happened right away. That would cut interest income to 10.8% and 11.95% respectively.

We see then that their high income would be enough to compensate for even the very negative scenario laid out above and thus deliver a net positive return on NAV. Furthermore, this analysis doesn't even take into account subsequent years in which default rates would fall and rising interest rates would gradually raise yields. Thus, to answer the question “has this drop created a buying opportunity?”-- the fact that it increased yields for buyers to the point where they were able to compensate for potential losses indicates to me that the answer is yes.

Now, is this price point the bottom? It's hard to say, but probably not. However, looking for the bottom exposes you to the risk that you miss out on what I believe is still an excellent entry point. Buying now will get you a very large yield which can cushion you against the many risks that face all bond investors. Furthermore, it's very possible that the current rally is yet another swing in a U.S. market whose long term destiny is to trade sideways for quite some time. In that case, interest rates would remain near zero, bonds would return to favor, and the current price would look quite favorable indeed.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in PHT, DHF over the next 72 hours.