Is It High Time For High-Yield Bond Funds?

HUH? High-Yield Bond?
All corporations need money, but not all corporations are created equal.  Management makes choices on how to get capital, and many turn to investors in the bond market for debt financing.  In return for interest payments, investors turn over cold hard cash.  The more a company is perceived as being able to make good on their debts, the lower their interest rate or cost of capital.  The higher the risk of a company, the higher the interest rate or yield.  This is where High-Yield, also known as below-investment grade, speculative grade, or junk, bonds come from.

The iShares iBoxx $ High Yield Corporate Bond Fund (HYG)
According to Briefing.com the afternoon of Christmas Eve, the yield spread on High-Yield Corporate Bonds was at a ridiculous +1982bps.  The yield spread is the difference between the quoted interest rates on two comparable groups of bonds.  In this case, it compares high-yielding junk bonds with similar Treasury bonds backed by the full faith and credit of the US Government.  The yield spread can also be seen as the additional return investors demand for the additional risk.  A basis point (bp) is 1/100th of 1 percent and a commonly used measure in the bond world since measures and differences of interest rates are often of a relatively small magnitude.

Why did Briefing.com call a nearly 20% yield spread “ridiculous”?  The long-term average High-Yield yield spread is somewhere in the neighborhood of 500bps.  This makes sense as the historical default rate on junk bonds is also around 5%.  In a reasonably large portfolio you might also expect 5% or less of your bonds to default.  Earlier this month the spread was as high as 2100bps, but has slowly started contracting.  Has this signaled a turn in the economy?

Perhaps. But what is more likely is the market looking to make a quick buck.  This is clearly evidenced in the iShares iBoxx $ High-Yield Corporate Bond Fund (HYG) ETF.  It has seen a significant rally in the last few weeks.  As of market close on Christmas Eve HYG had a net asset value (NAV), or underlying value, of $67.22, yet it was trading at a market price of $73.90. That means traders were paying a whopping 10.2% premium for this basket of junk bonds over the summed market value of the individual components of the basket.  So what’s the attraction?

For an industry that talks in basis points, 21% is a huge deal.  Even when the tech industry went bust at the turn of the century, yield spreads were in the neighborhood of 12%.  The market has certainly priced in some very deep economic distress.  For the yield spread to come back down to near average levels there are about 1500bps left for it to fall.  The rule of thumb is that when a bond’s yield falls, its price goes up.  The annualized distribution yield on HYG is currently 12.5% at NAV or 11.3% at market price.  Investors are not only anticipating price appreciation of the underlying assets, but also a payment of about 1% of their investment every month.

A Replay of The 80’s?
Whether the movements of HYG signal a shift in investor confidence or just traders looking to make money as usual, in the bond world, one man’s junk truly is another man’s treasure.  Coming out of recessions high-yield bonds often produce equity like returns.  Furthermore, with hedge funds closing left and right and forced to sell assets, you can pick up some of these bonds for pennies on the dollar.  Just last week the WSJ reported that former investment bankers from Drexel Burnham Lambert have teamed up at Trian Partners to have another run at the junk bond market.  Drexel Burnham was the nation’s fifth largest investment bank in the late 80’s thanks to its navigation of the credit markets.  It is also best known for being driven into bankruptcy after racketeering and securities fraud charges were brought against top employee Michael Milken, also known as the Junk Bond King, for illegal activities in the high-yield market.

In conclusion, HYG certainly seems like an ETF worth looking at, especially if its lofty double-digit market premium comes down.  Just remember: where there are higher returns there is often higher risk.  For comparison, HYG traded as high as $101.70 nearly a year ago and as low as $62.50 late last month.  Also, the constant 1% stream assumes that the current distribution on HYG stays the same and for the underlying basket of bonds to hold their price or to appreciate.  For that to happen, none of these bonds can go in to default during what looks to be a very severe economic downturn.  There are certainly investors out there that think credit markets are near the bottom.

Thursday, December 25, 2008, 12:08 | posted in the markets | 2 comments »