Dividends & Income Digest: Downtown Investment Advisory Explains Why High Yield Bonds Deserve A Spot In Your Portfolio

|
Includes: ACP, AIF, AMZN, ANGL, ARDC, CIF, CIK, CJNK, CSCO, DHG, DHY, DLNG, DSU, EAD, ET, FHY, GE, GGM, HIX, HYG, HYIH, HYLD, HYLS, HYT, IVH, JNK, JQC, JSD, KIO, KMI, MCI, MHY, MPV, NHS, PCF, PHF, PHT, QLTC, RA, SCHD, SJB, UJB, VLT
by: Robyn Conti
Summary

Every issue, SA explores a Dividends & Income investing topic.

Today, Downtown Investment Advisory, an SA contributor and creator of The High Yield Bond Investor newsletter, explains the benefits of high yield bonds and why he's so bullish on the asset class.

What should Seeking Alpha be tracking in the Dividends & Income world? Leave a comment to let us know. Or better yet, submit an article of your own.

At Seeking Alpha, we tend to be laser-focused on equities. After all, that's where investors generally find the biggest bang for their buck. As a result, though, we may overlook other asset classes that offer equivalent, if not better, returns over time -- like high yield bonds.

In this issue of the Dividends & Income Digest, Salo Aizenberg of Downtown Investment Advisory explains why he's bullish on high yield bonds, why investors should pay attention to this asset class, and why the term "junk bonds" is outdated.

Seeking Alpha: You write quite a bit about high yield bonds, and it seems you've been encouraging investors to "take the plunge" into these instruments since about October 2015, as far as I can tell from the articles you've posted on Seeking Alpha. What about that time period made high yield bonds attractive, and what makes them appealing for income investors now?

Salo Aizenberg: I have been investing in high yield bonds for many years now, so although I have been recommending these instruments for the last few months I have been positive on these types of corporate bonds for much longer. I view this asset class as an alternative to the more volatile stock market, which many investors remain wary of, and the ultra-low yields available on treasury bonds and most classes of investment grade bonds. Ten-year Treasury yields are at their lows for the last two years and at the same time, the stock market is stuck in a holding pattern, basically flat for the last 20 months with seemingly little to propel it forward. With this in mind, the yields on high yield bonds are particularly appealing today and can offer an investor with a multi-year investment horizon a way to lock in a reasonable return with less risk than stocks.

SA: It seems using the term "junk bonds" to describe high yield bonds is something of a misnomer these days. However, many investors still avoid them -- even the professionals. What's your take, and why would you advise investors to ignore this long-held moniker?

Salo: I view high yield bonds, also known as "junk bonds," as one of the least understood asset classes among investors, including professionals. Many asset allocation models do not specifically include high yield bonds, or add in a small percentage as some "alternative" investment to include with great caution. The word "junk" seems to scare away investors -- even though this asset class is far less risky than stocks, but no one would call stocks a "junk" investment.

I consistently remind investors I work with that over the last 25 years, returns on high yield are close to stock market returns, but with 40% less risk.

Over the last 10 years in particular, high yield returns have outpaced stock market returns by 3% per annum, again with 40% less risk. With these results in mind how can allocation models ignore the asset class? In the last two market crashes (2000-2002, 2008), high yield bonds performed far better than stocks, another important market for investors seeking to reduce risk. The word "junk" goes back to the 1980s and the days of Drexel Burnham and the birth of the high yield bond market -- at that time, the moniker was warranted. Today, high yield bonds are simply corporate bonds from issuers that the rating agencies have decided are not at least BBB-/Baa3. There is no magic that suddenly makes a BB rated bond "junk."

SA: What is your view of high yield bond funds? In your opinion, what is the best way to invest in them?

Salo: Investors need to understand that a high yield bond, like any corporate bond, is simply a contractual obligation between a company and the bondholder to pay the investor interest every six months (typically) and principal back on the maturity date. Each bond is thus its own investment unit and can be evaluated and purchased on its own merits, not as part of some larger "asset class" that is in favor or out of favor at the moment. Bonds can be decoupled from being part of a monolithic asset class. The only analysis necessary to evaluate a bond is deciding if you think the issuer will go bankrupt -- forget P/E ratios and technical charts -- can the issuer pay its interest and principal, and is the risk of bankruptcy negligible?

My strategy is to evaluate each bond on its own merits, ignoring the movements of high yield as an asset class, and create a diversified portfolio of bonds that I am happy to hold through the maturity date. In this way an investor can ignore the ups and down of the market. Bond funds do offer good diversity and are certainly appropriate for smaller investment amounts, but also expose investors to market segments they may want to avoid -- like the lowest rated CCC bonds and risky energy names. An index fund by definition has exposure to all these segments. While I prefer to do my own credit analysis and create my own portfolio of bonds, if an investor needs to use a fund, I would recommend a curated fund, not an index fund (for stocks, I recommend the opposite!).

SA: It appears you tend to follow some of the riskier names/sectors, i.e., energy, business development companies (BDCs), which makes sense given their high yield potential. What opportunities do you see in these sectors right now? More specifically, can you give examples of some of the names you follow, and offer some insights on why you like them?

Salo: I actually follow all high yield sectors, but there is great interest in the energy sector since it comprises a significant portion of the high yield market. The energy crash caused high yield to have negative returns in 2015, only the fifth time since 1980 that high yield bonds had negative returns. If you look at high yield excluding energy & mining, the statistics (e.g., default rates) look quite healthy.

Commodity-based businesses are inherently more volatile and I remain wary of oil & gas production and mining companies. Even before the crash, the exposure in these sectors in my managed portfolios was limited. I do like the pipeline companies, which is a good case of the "baby thrown out with the bath water." If you look at the actual operating cash flow results for these companies in 2015 and 2016, they show remarkable stability in the face of a 70% decline in oil prices. The equity values justifiably got hit and may still be overvalued as growth appears to be limited and distributions strained. But debt service is well covered. I recommended Kinder Morgan (NYSE:KMI) bonds when they were down, and still do so, even though they are not a bargain anymore (and are not technically high yield although they traded this way). BDC stocks I view as risky and not actually a fixed income investment, but the "baby bonds" of the BDCs I find attractive as they provide 2x asset coverage by regulation.

SA: Some economists are forecasting that a potential recession may be on its way. Is the high yield market giving any indication about this either way, and do you agree that we might, indeed, be headed for recession?

Salo: I make it a point to never make predictions about the direction of the market or the economy. That being said, eventually there will be a recession; it is inevitable. I don't think the high yield market is a good litmus test of where the economy is going. It seems to respond to many other factors from stock market movements to oil prices. To defend against a recession, it goes back to my earlier comment -- perform the credit analysis and pick high yield issuers that can survive a recession. One thing I look at is how the company managed in 2008-2009 -- this is a pretty good data point for how a company performs in an economic downturn.

SA: Your bio mentions you provide investment advisory services to retirement plans, which I know has more to do with investment policy statements and fiduciary issues and the like. However, if you're comfortable weighing in, as an extension of that expertise, how would you suggest retirees position themselves in light of the current economic environment? Where do bonds fit into such a strategy?

Salo: My service to 401(k)/403(b) plans focuses on providing plan sponsors a lineup of mutual funds that is focused on a diversified selection of the lowest cost index funds. I partner with Charles Schwab to deliver turnkey retirement plans -- my firm provides the investment advice and mutual fund lineup. Most incumbent plan providers receive fees from the mutual fund companies for selecting their fund for a retirement plan. While disclosed, this is a shocking conflict of interest, which is getting more scrutiny by the regulators. Since I don't get paid by the mutual fund companies, I select the best and lowest cost mutual funds available. The last plan I completed, with about $3 million in total plan assets, reduced the all-in cost from 1.2% per annum to 0.68% per annum.

For retirees and current investment allocations, there is never one answer. It depends on various factors from risk tolerance to income needs, and I would suggest that retirees create an allocation plan. But I would say high yield bonds offers an excellent way to avoid on one side the often gut wrenching volatility of the stock market, and on the other side the impossibly low yields of CDs and other bonds. We have several retired clients who have moved completely away from both these asset classes and are enjoying the steady income stream from a diversified portfolio of high yield bonds that they intend to hold to maturity.

SA: Is there anything else you'd like to share with readers?

Salo: My main message about high yield bonds is that they should be included in everyone's asset allocation plan, which for most investors certainly should include stocks and other types of bonds. But it is not an asset suited for trading; holding the individual bond is the best way to invest in high yield as an investor benefits from the certain maturity date and fixed interest payment to lock in a return. Many investors are not familiar or comfortable delving into the bond market, but the Seeking Alpha community is certainly more capable of doing so than the average investor. There are various quirks and nuances that must be understood, and credit analysis, especially in varied industries, takes time to master. My recently launched High Yield Bond Newsletter was established to help the investor who is comfortable buying bonds on their own but needs expertise to perform the credit analysis and find good values. The newsletter follows my philosophy of investing in solid credit quality, 5%-8% yielding bonds with a buy-and-hold to maturity expectation.

Now it's your turn to weigh in. Do high yield bonds have a place in your portfolio? Do you agree that they're a viable way to avoid stock market volatility? Do you believe "junk bonds" is no longer a viable name for this asset class? Why or why not?

And now, on to the week's Dividends & Income news and analysis:

My First Year With SCHD As A Dividend Growth Investment by David Van Knapp

General Electric: 50% Dividend Growth Opportunity Hiding In Plain Sigh by David Alton Clark

The Best Fixed Rate Preferred Stock by Arbitrage Trader

Can Energy Transfer Equity Maintain The Distribution? by Ray Merola

Dynagas LNG: A View From The Perspective Of A Preferred Investor by Norman Roberts

OK, I Admit It: There's Life Beyond The Dividend Growth 50! by Mike Nadel

Retired Investors Should Give This Blue-Chip Technology Stalwart A Close Look by Chuck Carnevale

Prospect Capital: Some Things Never Change by Charles Gooch, Jr.

Amazon Is Growing Like A Weed: Cash In On REIT Landlords - 2016 Update by Bill Stoller

A Canadian Looking South For Long-Term Dividend Growth by Innzkeeper

And one more thing... Huge, abundant gratitude to all who answered my call for more followers in the last Digest. Thanks to you, I am now at 1528 and counting. I'm so grateful for your ongoing support. Stay tuned, because there's more good stuff to come!

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.