The Investment U e-Letter: Issue # 408
Monday, January 31, 2005 High Yield Bond Funds… Time to Sell This Investment A barrel of this company's product costs 14,448 times more than oil. It's a commodity that you and I, and every other human being, simply cannot live without. And yet, there is an appalling scarcity with oil-like supply shocks and surging worldwide demand triggered by natural and human-caused disasters. Learn more here. |
By Dr. Steve Sjuggerud, Advisory Panelist, Investment U
"Yesterday's weeds are today being priced as flowers." Warren Buffett said that nearly a year ago. He was talking about high yield bond funds… and it's only gotten worse… As of today, those high yield bond fund "weeds" of a year ago are now priced like Dutch tulips in the 17th century, which were bid up to irrational heights only to come crashing down. High yield bond funds (or "junk" bonds, as they're commonly called) are now at irrational heights. Unfortunately for investors holding them, they will likely follow the tulips. If you own any high yield bonds now (or any particularly risky type of bond, like emerging markets bonds), it is time to sell. Get out now. Here's the story… The Rule for When to Buy High Yield Bond Funds, and When to Sell "When the spread is high, it's time to buy," I wrote in the December 2002 issue of my newsletter True Wealth. And boy the spread was wide. At the time, U.S. government bonds were paying 3.75%, and high yield bond funds were paying 10 full percentage points more than that. So we bought. The trade turned out fantastically… True Wealth readers made approximately 40% in a year - in bonds! "When the spread is low, it's time to go." And right now, high yield bonds only pay 3% above Treasury bonds. It's time to go. Now, things are exactly the opposite of late 2002. The rule is: Over the last 20 years, junk has typically paid about 5 percentage points above whatever Treasury bonds are paying. In late 1990 and late 2002, high yield bond funds paid a full 10 percentage points above Treasury bonds. Those were fantastic times to buy. Not now. The Basic Idea: When the World Seems Fine, Don't Buy High Yield Bond Junk Before the Crash of '87, the financial world seemed safe. Junk bonds reflected that, as they were only paying about 4 percentage points above Treasuries. And then the Crash hit… and a recession followed just a few years later. High yield bond fund investors were obliterated, as defaults increased and yields rose (as a rising bond yield equals a falling bond price). By January of 1991, junk bonds were paying about 10 percentage points over Treasuries. In 1997, the financial world once again seemed safe. Junk bonds were paying about what they are now, 3 percentage points above Treasuries. But by 2002, after the Nasdaq bust, things looked terrible. Nobody wanted any risk. And high yield bond investors were obliterated once again, even worse than the previous example. Now in early 2005, the financial world seems safe once again. And once again, risky bonds are paying next to nothing - just 3 percentage points above Treasuries. We've seen this movie twice before now. We know what to do. The time to buy high yield bond funds is when people are scared… when we are in recession. And when nobody wants them. Unfortunately, now is not a time to buy high yield bonds. Owners of risky bonds are simply not being compensated for the risk they're taking right now. You can understand how investors put themselves in this predicament. They simply got tired of the low interest rates that "safe" investments pay. So they've over-reached. They've extended themselves into the "risky" area of high yield bonds to try and boost their yields. In short, that arm reaching out for a little more yield is likely to get cut off in 2005 or very soon after. If the bust doesn't come in 2005, be certain that the time is near. Good investing, Steve Today's Investment U Cribsheet - For more information on high yield bond funds as well as municipal and government bonds, asset-backed securities and more check out http://www.investinginbonds.com. You'll find great educational information on coupon rates, maturities, yields and other features, as well current rates on a broad range of bond investments.
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