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Why Buy High Yield Bond Funds?

by: Avi Morris September 15, 2008 | about stocks: HYG / JNK / PHB    

Avi Morris

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I've been investing in high yield (more commonly known as junk) bonds for years, which has taught me a lot about their ups and downs. I hope this information can be used to give guidance for future investing.

History

In the 1980s, a few junk bonds were available on the NYSE and the over-the-counter market. Not only did they offer high yields, but brokerage commissions were modest. The high yields on junk bonds were necessary because their bond ratings were generally rated B or even CCC (BBB is the minimum rating for investment quality bonds). While the high yields were attractive, bumps in the road reinforced the idea that they also carried risk (i.e., bond defaults).

Eventually these bonds were seen by major financial firms as investment products which could be combined in ETF bond funds. About 20 years ago, a number of junk bond closed-end funds were sold at $10 a share with a 10¢ monthly dividend ($1.20 yearly). In their early years, the stocks slipped, sending yields towards 15%. Then came the very ugly credit crisis around 1990.

These funds performed badly, similar to the performance of a portfolio managed by any amateur. So much for "professional management." The portfolios took terrible beatings in stock prices because of their large dividend cuts. Over time, markets adjusted to lower dividends and stock prices settled at lower levels. During the remainder of the 1990s, these funds paid fairly stable dividends with stock prices remaining stable based on roughly 10% yields. Then came the very, very ugly 2000+ period.

These funds again were supposed to be managed by expert managers. However, they turned out to be just ordinary young guys who had not learned their lessons or professional discipline. They bought junk bonds in sexy tech companies with very high yields as others were buying stocks in the same companies. When the market crashed, those bonds headed south following the corresponding stocks. The so-called financial professionals found that junk bonds were really just stocks with high yields capable of suffering similar terrible losses as did stocks. After a couple of dreary years, declining dividends (net investment income) for the junk bond funds leveled off with relatively steady prices with steady dividends and yields.

A few calm years with fairly stable dividends were followed by the credit crunch in mid 2007. Through early 2008, prices and dividends for the bond funds held up pretty well. High yields were a powerful attraction, plus they have no mortgage exposure, requiring no mortgage writedowns. Corporate defaults are the main worry for junk bonds. The severe downturn in stocks during the last few months bled through to junk bond funds, sending them lower with falling prices raising their yields to almost 13% (as of September 2008).

Operations

The business for junk bond funds (also called ETFs) is to invest in bonds typically with below investment ratings (again, BBB is the lowest investment grade). They collect bond interest, pay expenses and the remainder (net investment income) is paid in dividends. Many funds use leveraged bond accounts to increase investment income. For example, $100 million of equity might be used to borrow an additional $40 million. The difference between the money earned on investments versus interest paid on the borrowings adds to net investment income for stockholders.

Tax issues

Taxes on dividends (net investment income) is pretty straight forward, it's taxable ordinary income. Occasionally a small percentage might be classified as qualified dividends (if they collect dividends from companies paying qualified dividends), capital gains or could even be tax free. These are exceptions & are typically only minor in influence.

Valuing junk bond funds

Valuing junk bond funds is based on (1) current rates and (2) the premium over the US Treasury bond rate. High yield funds yields typically have yields of 8-10%, similar to yields on the high yield bonds. Each fund owns many bonds, giving a diversified and average return for their investment portfolio.

Yields and yield spread over treasuries

Junk bonds have yields around 8-10%, except during tough financial times. During difficult times - 1990, 2000 and now -  rates increase into double digits. In addition, junk bonds are expected to yield around 400-450 basis points above the Treasury rate. The Treasury rate today is near 3.6%, while junk bonds yields approach 13%, more than triple the Treasury rate. In the past, periods when the spread has gotten excessive have proven to be opportune times for locking up very high rates. High rates should last for a good five years forward. If rates drops, the corresponding stock price increases will add to gains.

Outlook

The outlook is favorable for junk bonds. Recently, I've had meetings with fund managers and they are optimistic about high yield bonds. Of course they have a bias; their job is to be optimistic. As noted, current yields are quite high and the spread over Treasuries at 900 basis points suggests very good values. Loan defaults are the main risks on these investments. The outlook for defaults is good - they are not expected to reach the very high levels seen in the 2000 era when defaults exceeded 10%. Traditional default rates are about 2%. That rate may rise, but is not expected to approach the extraordinary rates reached at the start of the decade. The very brave may want to consider these investments with high yields to help ride out what looks to be an extremely tough time for stocks (especially financials).

Disclosure: none

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This article has 8 comments:

  •  
    Sep 15 01:02 PM
    I hope you dont need to cash them...
    Reply
  •  
    Sep 15 02:04 PM
    'The outlook for defaults is good - they are not expected to reach the very high levels seen in the 2000 era when defaults exceeded 10%.

    So why is it different this time?
    Reply
  •  
    Sep 15 02:41 PM
    The junk bond ETFs you cite above all have yields between 8-10%.
    Reply
  •  
    Sep 15 04:50 PM
    I own HIX, which yields over 12%. FAX, which is about 75% AAA-rated, is yielding over 8%.
    Reply
  •  
    Sep 15 06:34 PM
    The problem for many high yield bonds now is not just the default rate (where anyway every fund manager will argue that he has "unique insights" in picking solid businesses) but refinancing risk - the borrowers can pay interest, but the principal of many of the recent bond vintages cannot easily be repaid from company cash flows: the bonds were placed in the expectation that they could be redeemed by replacing them with abundant cheaper finance a few years down the line, or in conjunction with IPO's of the borrowers.

    So crunch time is delayed until the final redemption date. Investing now is a bet that credit conditions will get back to where they were: your call if you think this is likely, but many borrowers don't really have a plan B.
    Reply
  •  
    Sep 16 08:42 AM
    What's the alpha on junk bonds? In other words, how do actively managed funds compare to index funds?
    Reply
  •  
    Sep 19 07:12 PM
    Never look at the damned things except on dividend payouts. It could shorten you life and screw up your disposition. Other than that go ahead, its no worse than killing a bottle of vodka to get the cork for your collection. Good grief.
    Reply
  •  
    Oct 08 10:51 PM
    A good article on junk bonds if only to alert investors that during junk bond bear markets the dividends are reduced. My only objection is the default rates on junk bonds are projected to hit record levels in 2009. As an aside, this is now officially the worst junk bond bear market of all time. I never thought I would see anything like 89-90 but this one takes the cake. I am drooling over the prospects of the next next bull market in junk bonds hoping it will be similar to 1991, but it may be a very, very long wait.
    Reply
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