High Yield Bond Market
Content
High Yield Bond Market Investment Opportunities
By Steven D. Landis, CFP® Sojourn Financial Strategies, LLC
Yashvardhan Rajgarhia Roll No:52
Summary
Introduction High-yield bonds, or "junk bonds" as they are widely known, have become the subject of quite a bit of attention in recent months. That's because, as of August 31st, the Barclays and Merrill Lynch high-yield bond indexes have jumped over 40% in value so far in 2009. This makes the S&P 500 Index's year-to-date return of only 14.97% as of August 31st paltry in comparison. Junk Bonds Most of us realize that high-yield bonds are called "junk bonds" because they carry a much higher risk of default than government or high-grade corporate bonds. As a result, these bonds tend to carry a higher rate of interest in order to compensate investors for taking on a greater risk of default. Like all bonds, high-yield issues tend to be affected by the interest rate climate. However, what you may not know is that the value of a high-yield bond can also be affected by the health of the economy and stock market. It just makes sense that a better economic environment sometimes reduces a junk bond's default risk, since the issuing corporation may be less likely to default in a good economy. As a result, the spread between the effective junk bond yield and a risk-free (Treasury) rate closes, and the underlying bond becomes more valuable. Of course, the skill in managing high-yield bonds or junk bond mutual funds comes in knowing when to be in the market and when to move to cash. High yield bonds have been around for longer than most of us can remember. Anybody who was born earlier than 1960 can recall the days of Ivan Boesky and Michael Milken, the highly creative and somewhat dubious creators of "junk bonds" (the more-to-the-point term for high yield bonds). Eventually, their actions, not the junk bonds, landed the boys in jail for a short time. It should be noted that never was there (then or now) anything illegal about the use of the junk bonds, but their criminal activity, in part, contributed to the bad reputation sometimes attributed to high yield bonds. Fast forward to today and we find that more than $500 billion (a halftrillion dollars) defines the magnitude of the high yield bond market. Its explosive growth is the result of two factors: 1) more companies needing capital; and 2) the availability of investors who are willing to take more risk in return for a higher yield on their investment. Bond Ratings
Bonds are rated based on the probability of the borrower defaulting on the bond, that is eventually failing to meet the terms of the bond covenant. The highest quality bonds, those with the greatest probability of paying back the loan principle and interest, are rated AAA. As the chances of a bond default increases, the lower the rating on the bond, as illustrated in Table 1 below Standard & Poor's Grade Rating AAA Investme nt AA Investme nt A Investme nt BBB Investme nt BB, B Junk CCC, CC, C Junk D Junk Default Risk Lowest Risk Low Risk Low Risk Medium Risk High Risk Highest Risk In Default
Risks of investing in high yield bonds In 2007, investors and the public became intimately familiar with the subprime consumer mortgages and their risk to lenders (and ultimately the economy, in general). The results of consumers overextending themselves by borrowing more debt than they could repay, under terms that were unfavorable, eventually resulted in a near-collapse of the consumer mortgage market. Investors in those sub-prime mortgages soon found their investments suffering tremendous losses. Meanwhile, the ability to sell out of those investments became more and more difficult due to a lack of buyers. A similar scenario also played out in the high yield bond market in which holders of low-quality debt saw their investments lose a substantial percentage of its original value. A fact of life is that consumers with low credit scores must pay high interest rates when they borrow money. This higher interest rate compensates the lender for the increased chance of the borrower defaulting on the loan. Likewise, corporate borrowers with a lower credit rating have an increased probability of defaulting on their loans and pay lenders accordingly. Those who loan money to these corporate borrowers demand to be compensated for the extra risk they take in making these loans. Should a default occur, the bondholders stand in line with all the other creditors of the company, hoping to get back some portion of their money. The lower the quality the bond, the less chance there will be
assets that can be used to pay back creditors. The increased interest rate compensates the lender, at least in part, for this additional risk. The result is that those entities that lend money to higher risk borrowers, via junk bond offerings, receive a higher interest rate than if they had been lending money to higher quality (lower risk) borrowers. To illustrate this difference, consider that over the past twenty or so years, high yield bonds have paid an interest rate of 3-9% (with an average of 6%) per year more than that of U.S. Treasury bonds. This difference is known as the "spread." In early 2008 the average default rate on junk bonds was about 1.1%. However, as the economy continued to sour the default was expected to increase to around 5.2%. Compare this with an average, longterm default rate of about 4.9% (according to John Lonski, chief economist of Moody's.) An additional risk of junk bonds is their lack of liquidity. Liquidity refers to the ease of trading the instrument in the marketplace. The author of this paper also refers to liquidity as "how quickly one can sell an investment and convert it to cash". Junk bonds are not traded as freely as, say, government bonds. Thus, the liquidity of high yields is significantly lower than that of high quality debt, which leads to higher costs of trading and selling at one's desired price. All of these factors combined result in the higher interest rate that is attached to junks. Why Invest in High-Yield Bonds? Unlike normal bonds, that are greatly influenced by fluctuations in interest rates, junk bonds are less affected by interest rate movement. This is because junks generally have higher interest rates and have, generally, shorter maturities. In fact, junk bonds are affected more by overall economic changes (expansion or contraction) than changes (increase or decrease) in prevailing interest rates. This is because the quality of a junk bond is most affected by the strength of the company issuing the bond. If the company's profitability increases (since the issuance date of the bond), the quality of their bonds increases. For an investor in a junk bond, this is an almost-perfect scenario: One in which a junk bond with a high interest rate becomes a quality bond with a high interest rate (this being the result of the formerly high risk borrower becoming a low risk borrower). For example, ABC Corp. had a debt rating of "B" and issued a bond at 12%. Meanwhile, AAA-rated debt was paying 4%. Sometime following issuance of this debt, ABC Corp. enjoys a return to profitability and its debt rating is upgraded to "A". The result is that holders of those old ABC Corp. bonds now hold A-rated debt that is paying 12%! This, in turn, makes the underlying bond more valuable since investors are willing to accept a lower rate of interest on debt issued by a stable company.
How to Invest in High-Yields In my opinion, investing directly in individual junk bonds should be left to the wealthy and institutional investors. In fact, the majority of investors in junk debt are institutional…mutual funds, pension funds, hedge funds, and others. This, however, does not suggest that investing in junks is only for the wealthy. Most all investors can get involved with junk bond investing by investing in mutual funds that specialize in them. By investing in a mutual fund that specializes in junk bonds, an investor can take advantage of a professional fund manager. Additionally, the investor will be able to reduce risk via the diversification that mutual funds offer. (A typical mutual fund will hold as many as 200-400 bonds, all of which are owned, on a pro rata basis, by investors in the fund.) Keep in mind, though, that investing in a mutual fund does not mean that the investor has no risk. Like the bonds held by the fund, a mutual fund can gain or lose value. Plus, in the event of a slowing economy, high yield bond mutual funds can lose significant value. So, for anybody considering an investment in high yield bond funds (or for that matter, any mutual fund) consider your tolerance for and ability to withstand potential losses. An Improvement on Buy-and-Hold Bond Investing As much as we really like investing in high-yield bond funds, they have one major flaw. That flaw is that there are times in which high yield bonds (and mutual funds investing in them) will get absolutely annihilated in a bear market. The years 2007 and 2008 are the most recent examples of this. In 2008, the majority of high yield bond mutual funds lost more than 20% of their value. Worse still were those funds that lost more than 50% of their value! Risk-averse investors may find themselves asking: "Is there a way to invest in high yield bond funds without the risk of losing money in a down market?" Fortunately, the answer is, "Yes, there is." There are any number of advisers whose role is to actively manage money for their clients. (The author of this paper is among those who manage money for investors who want to invest in high yield bond funds.) The goal for most of these advisers/managers is to be invested in a security/market when it's gaining in price and to sell that security/market before its price goes down too much. If the adviser is able to do this buying and selling successfully (and we emphasize "IF"), then that adviser's clients/investors would be able to make more profit while taking less risk. By reducing the losses during time periods in which high yield bonds are losing money (1998-2002 and 20072008) one can dramatically improve the potential for long-term profits. Is the Party Over for 2009?
At this point, readers of this paper are either eager to invest in high-yield bond funds or skeptical and not interested in the increased risk. For those who are tempted to invest in the high-yield bond market, a question arises: "How much profit is left after the big run junks have had this year?" It goes without saying that we have no idea how much more high yields can offer. But we can offer a look at three possible scenarios: Scenario 1. The Economy Improves. If the economy continues to improve, profits of most corporations will rise. At the same time, we would expect profits of many issuers of high yield debt to improve. If this scenario does, in fact, occur then we would expect high yield bonds to continue increasing in price. (Additionally, bondholders would continue to receive interest payments from those bonds.) Scenario 2. The Economy Sours. If the economy begins to worsen, then corporate profits will likely be depressed. At the same time, profits of issuers of high yield debt would probably suffer. In this scenario, the prices of high-yield debt would probably begin to fall. The buy-and-hold investor would suffer losses to his/her investment. Investors who use skilled, successful active managers have a great probability that their adviser/manager would sell their junk bond fund and invest their money in the safety of a money market fund. This move to safety would preserve the value of investors money. Scenario 3. The Economy Muddles Along. If the economy becomes listless and neither grows nor contracts, there is the possibility that high-yield bond prices could stagnate. That is, prices would neither rise nor fall. It would be extremely rare for this to continue for an extended period of time, but let's assume it does. In such a situation, the investor neither gains nor loses money on his/her investment principle. However, he/she could continue to reap profits in the form of high interest income being generated by the bonds. So, looking at the three possible scenarios, the only one that we would expect to pose a threat of significant loss is Scenario #2, specifically for the buy-and-hold investor. The investor who uses a skilled, active adviser/manager has a significantly greater chance of avoiding losses during a "down market". [There are no guarantees, of course. GDH] In summary, we contend that high yield bond mutual funds can be an extremely attractive way to invest, though subject to substantial losses during falling markets. Furthermore, we believe that investing in high yield bond mutual funds can be an even more attractive method of investing, if managed under the guidance, direction, and oversight of an experienced and skilled adviser.
By Steven D. Landis, CFP® Sojourn Financial Strategies, LLC
Yashvardhan Rajgarhia Roll No:52
Summary
Introduction High-yield bonds, or "junk bonds" as they are widely known, have become the subject of quite a bit of attention in recent months. That's because, as of August 31st, the Barclays and Merrill Lynch high-yield bond indexes have jumped over 40% in value so far in 2009. This makes the S&P 500 Index's year-to-date return of only 14.97% as of August 31st paltry in comparison. Junk Bonds Most of us realize that high-yield bonds are called "junk bonds" because they carry a much higher risk of default than government or high-grade corporate bonds. As a result, these bonds tend to carry a higher rate of interest in order to compensate investors for taking on a greater risk of default. Like all bonds, high-yield issues tend to be affected by the interest rate climate. However, what you may not know is that the value of a high-yield bond can also be affected by the health of the economy and stock market. It just makes sense that a better economic environment sometimes reduces a junk bond's default risk, since the issuing corporation may be less likely to default in a good economy. As a result, the spread between the effective junk bond yield and a risk-free (Treasury) rate closes, and the underlying bond becomes more valuable. Of course, the skill in managing high-yield bonds or junk bond mutual funds comes in knowing when to be in the market and when to move to cash. High yield bonds have been around for longer than most of us can remember. Anybody who was born earlier than 1960 can recall the days of Ivan Boesky and Michael Milken, the highly creative and somewhat dubious creators of "junk bonds" (the more-to-the-point term for high yield bonds). Eventually, their actions, not the junk bonds, landed the boys in jail for a short time. It should be noted that never was there (then or now) anything illegal about the use of the junk bonds, but their criminal activity, in part, contributed to the bad reputation sometimes attributed to high yield bonds. Fast forward to today and we find that more than $500 billion (a halftrillion dollars) defines the magnitude of the high yield bond market. Its explosive growth is the result of two factors: 1) more companies needing capital; and 2) the availability of investors who are willing to take more risk in return for a higher yield on their investment. Bond Ratings
Bonds are rated based on the probability of the borrower defaulting on the bond, that is eventually failing to meet the terms of the bond covenant. The highest quality bonds, those with the greatest probability of paying back the loan principle and interest, are rated AAA. As the chances of a bond default increases, the lower the rating on the bond, as illustrated in Table 1 below Standard & Poor's Grade Rating AAA Investme nt AA Investme nt A Investme nt BBB Investme nt BB, B Junk CCC, CC, C Junk D Junk Default Risk Lowest Risk Low Risk Low Risk Medium Risk High Risk Highest Risk In Default
Risks of investing in high yield bonds In 2007, investors and the public became intimately familiar with the subprime consumer mortgages and their risk to lenders (and ultimately the economy, in general). The results of consumers overextending themselves by borrowing more debt than they could repay, under terms that were unfavorable, eventually resulted in a near-collapse of the consumer mortgage market. Investors in those sub-prime mortgages soon found their investments suffering tremendous losses. Meanwhile, the ability to sell out of those investments became more and more difficult due to a lack of buyers. A similar scenario also played out in the high yield bond market in which holders of low-quality debt saw their investments lose a substantial percentage of its original value. A fact of life is that consumers with low credit scores must pay high interest rates when they borrow money. This higher interest rate compensates the lender for the increased chance of the borrower defaulting on the loan. Likewise, corporate borrowers with a lower credit rating have an increased probability of defaulting on their loans and pay lenders accordingly. Those who loan money to these corporate borrowers demand to be compensated for the extra risk they take in making these loans. Should a default occur, the bondholders stand in line with all the other creditors of the company, hoping to get back some portion of their money. The lower the quality the bond, the less chance there will be
assets that can be used to pay back creditors. The increased interest rate compensates the lender, at least in part, for this additional risk. The result is that those entities that lend money to higher risk borrowers, via junk bond offerings, receive a higher interest rate than if they had been lending money to higher quality (lower risk) borrowers. To illustrate this difference, consider that over the past twenty or so years, high yield bonds have paid an interest rate of 3-9% (with an average of 6%) per year more than that of U.S. Treasury bonds. This difference is known as the "spread." In early 2008 the average default rate on junk bonds was about 1.1%. However, as the economy continued to sour the default was expected to increase to around 5.2%. Compare this with an average, longterm default rate of about 4.9% (according to John Lonski, chief economist of Moody's.) An additional risk of junk bonds is their lack of liquidity. Liquidity refers to the ease of trading the instrument in the marketplace. The author of this paper also refers to liquidity as "how quickly one can sell an investment and convert it to cash". Junk bonds are not traded as freely as, say, government bonds. Thus, the liquidity of high yields is significantly lower than that of high quality debt, which leads to higher costs of trading and selling at one's desired price. All of these factors combined result in the higher interest rate that is attached to junks. Why Invest in High-Yield Bonds? Unlike normal bonds, that are greatly influenced by fluctuations in interest rates, junk bonds are less affected by interest rate movement. This is because junks generally have higher interest rates and have, generally, shorter maturities. In fact, junk bonds are affected more by overall economic changes (expansion or contraction) than changes (increase or decrease) in prevailing interest rates. This is because the quality of a junk bond is most affected by the strength of the company issuing the bond. If the company's profitability increases (since the issuance date of the bond), the quality of their bonds increases. For an investor in a junk bond, this is an almost-perfect scenario: One in which a junk bond with a high interest rate becomes a quality bond with a high interest rate (this being the result of the formerly high risk borrower becoming a low risk borrower). For example, ABC Corp. had a debt rating of "B" and issued a bond at 12%. Meanwhile, AAA-rated debt was paying 4%. Sometime following issuance of this debt, ABC Corp. enjoys a return to profitability and its debt rating is upgraded to "A". The result is that holders of those old ABC Corp. bonds now hold A-rated debt that is paying 12%! This, in turn, makes the underlying bond more valuable since investors are willing to accept a lower rate of interest on debt issued by a stable company.
How to Invest in High-Yields In my opinion, investing directly in individual junk bonds should be left to the wealthy and institutional investors. In fact, the majority of investors in junk debt are institutional…mutual funds, pension funds, hedge funds, and others. This, however, does not suggest that investing in junks is only for the wealthy. Most all investors can get involved with junk bond investing by investing in mutual funds that specialize in them. By investing in a mutual fund that specializes in junk bonds, an investor can take advantage of a professional fund manager. Additionally, the investor will be able to reduce risk via the diversification that mutual funds offer. (A typical mutual fund will hold as many as 200-400 bonds, all of which are owned, on a pro rata basis, by investors in the fund.) Keep in mind, though, that investing in a mutual fund does not mean that the investor has no risk. Like the bonds held by the fund, a mutual fund can gain or lose value. Plus, in the event of a slowing economy, high yield bond mutual funds can lose significant value. So, for anybody considering an investment in high yield bond funds (or for that matter, any mutual fund) consider your tolerance for and ability to withstand potential losses. An Improvement on Buy-and-Hold Bond Investing As much as we really like investing in high-yield bond funds, they have one major flaw. That flaw is that there are times in which high yield bonds (and mutual funds investing in them) will get absolutely annihilated in a bear market. The years 2007 and 2008 are the most recent examples of this. In 2008, the majority of high yield bond mutual funds lost more than 20% of their value. Worse still were those funds that lost more than 50% of their value! Risk-averse investors may find themselves asking: "Is there a way to invest in high yield bond funds without the risk of losing money in a down market?" Fortunately, the answer is, "Yes, there is." There are any number of advisers whose role is to actively manage money for their clients. (The author of this paper is among those who manage money for investors who want to invest in high yield bond funds.) The goal for most of these advisers/managers is to be invested in a security/market when it's gaining in price and to sell that security/market before its price goes down too much. If the adviser is able to do this buying and selling successfully (and we emphasize "IF"), then that adviser's clients/investors would be able to make more profit while taking less risk. By reducing the losses during time periods in which high yield bonds are losing money (1998-2002 and 20072008) one can dramatically improve the potential for long-term profits. Is the Party Over for 2009?
At this point, readers of this paper are either eager to invest in high-yield bond funds or skeptical and not interested in the increased risk. For those who are tempted to invest in the high-yield bond market, a question arises: "How much profit is left after the big run junks have had this year?" It goes without saying that we have no idea how much more high yields can offer. But we can offer a look at three possible scenarios: Scenario 1. The Economy Improves. If the economy continues to improve, profits of most corporations will rise. At the same time, we would expect profits of many issuers of high yield debt to improve. If this scenario does, in fact, occur then we would expect high yield bonds to continue increasing in price. (Additionally, bondholders would continue to receive interest payments from those bonds.) Scenario 2. The Economy Sours. If the economy begins to worsen, then corporate profits will likely be depressed. At the same time, profits of issuers of high yield debt would probably suffer. In this scenario, the prices of high-yield debt would probably begin to fall. The buy-and-hold investor would suffer losses to his/her investment. Investors who use skilled, successful active managers have a great probability that their adviser/manager would sell their junk bond fund and invest their money in the safety of a money market fund. This move to safety would preserve the value of investors money. Scenario 3. The Economy Muddles Along. If the economy becomes listless and neither grows nor contracts, there is the possibility that high-yield bond prices could stagnate. That is, prices would neither rise nor fall. It would be extremely rare for this to continue for an extended period of time, but let's assume it does. In such a situation, the investor neither gains nor loses money on his/her investment principle. However, he/she could continue to reap profits in the form of high interest income being generated by the bonds. So, looking at the three possible scenarios, the only one that we would expect to pose a threat of significant loss is Scenario #2, specifically for the buy-and-hold investor. The investor who uses a skilled, active adviser/manager has a significantly greater chance of avoiding losses during a "down market". [There are no guarantees, of course. GDH] In summary, we contend that high yield bond mutual funds can be an extremely attractive way to invest, though subject to substantial losses during falling markets. Furthermore, we believe that investing in high yield bond mutual funds can be an even more attractive method of investing, if managed under the guidance, direction, and oversight of an experienced and skilled adviser.
