High Yield Fantasy or Reality…

Last fall in this space we discussed the prospects of junk bonds in general and some junk bond ETFs in particular, and we feel it’s time again to revisit this issue for a number of reasons that will come clear below.

We’ll start with a scathing criticism we penned back in December of last year of a certain benighted ‘analyst’ by the name of Rakesh Saxena.  No normal dupe this chap, Mr. Saxena was pleading with his readers on SeekingAlpha at the time to short-sell the high yield bond ETFs, claiming a whole barrel-full of manure as his proof that they were headed for the dumper (to see our original comments – click here). 

We, of course, disagreed with him and gave him our coveted, Asinine Fool of the Year Award for 2008.  Here is what the high yielders have done since that time:

The chart above shows just one of the more popular – and better yielding – high yield ETFs on the market, the ishares iboxx high yield corporate bond fund (NYSE:HYG).  The shares have climbed a very handsome 35% since Mr. Saxena’s notorious short sell call in late November, 2008, and has paid monthly distributions that tally to roughly a 15% annual yield. 

But what of the present and future; this stuff is all history.

Then, we noted the enormous, near-unprecedented spreads between Treasuries and High Yield (Junk) bonds.  At the time they stood at 2100 basis points, a level that was clearly unsustainable.  At those levels the market was anticipating a 70% default rate in the bonds – clearly a sign of a market mispriced.  Only among the wackiest of whacked-out gold bugs was there a sincere belief that this would happen.  [The gold-bug fringe is the only place you'll find people who actually revel in the thought of wholesale economic and social chaos.]

Mr. Saxena did not strike us at the time as a radical gold buggerer, though he may well be.  We, too, by the way, like gold as an essential long-term holding.  But we’re also happy to readjust our position as the metal spikes and swoons.

Moody’s Looks For Trouble

That said, where is the junk market now and where is it going next?  According to Moody’s, July’s speculative grade corporate default rate was 10.7%, up from June’s 10.3%.   The raters expect this number to continue to grow this year and top out in the 12.8% range by the 4th Quarter of 2009 before recovering to 6.0% a year from now.

And that’s all nice and fancy, but remember, junk defaults reached their peak in 1991 at 12.2%, and that was, without question, the best time for investors to settle in to a broad, diversified swath of high yield debt issues.

And that brings us to today.

Buy, even though the Junk sector has already popped like a geyser?

Let’s take a minute to examine the basics.  First, junk bonds are called bonds, but they actually don’t trade like bonds at all; for the trader’s purposes, they’re stocks.  They trade like stocks and are little touched by movements in interest rates, long or short.  They move directly in line with the issuer’s underlying common stock, albeit in a slightly muted manner.  Certainly, when they’re sold off in a paroxysm of panic (as they were last fall), they’ll snap back like a catapult when the market smells recovery (as they did this spring and summer).  Triple C rated issues (the lowest rung of the junk totem pole) have rallied over 80% since March 9th of this year.  And we say there’s more to go.

The reasons are as follows:

1.    We are in a recovery.  It may be a fast recovery or a slow one (we would hazard the former), but either way, a recovery means, by definition, a narrowing of junk spreads to Treasuries.  The best proof we’re in a recovery is that this is precisely what’s happening now.  Look at the charts below:

The first chart depicts the last thirteen years’ worth of spreads as recorded by the Merrill Lynch High Yield Master II Index, and shows last year’s spike in the spread to have been a historical anomaly – and the junk bond buying opportunity of a lifetime.

The second chart focuses on just the last year and a half.  From here we see that pre-crash levels are in sight and will likely be bested within a few months, when the economic numbers show without a doubt that the recovery’s got traction.  At that point we would not be surprised to see spreads narrow toward 600 basis points.  Note well, that the historical norm for junk spreads over the last ten years has been 643 basis points.  And over the last 23 years, the average is just 507 basis points.  Look here:

2.    The next reason we believe there’s still upside to be had here is a little more nebulous, as it’s based on sentiment, something not so easily measured even with the best of tools.  It goes like this: there’s still a mountain of cash from pension funds, mutual funds, sovereign wealth funds and sidelined investors that’s waiting for an opportunity to jump in.  These people are itchy to make up time and money lost in last year’s debacle, but they’re still not sure the moment has arrived.  The fancypants types on Wall Street say these folks have ‘risk appetite’.  Our call is that they will begin exercising that appetite, i.e., eating, when the Dow serves them it’s first course at 9500.

To sum, there’s 10% worth of yield to be had in junk over Treasuries, plus price appreciation as those spreads diminish.  And there’s professional management to do the heavy lifting and sifting the good (junk) from the bad with the ETFs. 

So why wait?

The Residual Income Report recommends immediate purchase of HYG below $83, with no more than 7-8% of your total portfolio allocated to high yield.  HYG currently yields 10.59% annually.

Now go make a buck

Matt McAbby
Senior Analyst, Residual Income Report