High Yield Bonds, Part 2
An Investment More Profitable And Less Risky Than Stocks
Part 2 of a 2-part Investment U White Paper Report
By the Investment U Research Team
(Return to Part 1)
Bankruptcies: Evidence of Healthy Market Functioning?
Seven of the 10 biggest bankruptcies in U.S. history – worth some $335 billion of assets – occurred since 2001. These include (in billions of dollars in pre-bankruptcy assets):
Worldcom, 2002 $103.9
Enron, 2001 $63.4
Conseco, 2002 $61.4
Global Crossing, 2002 $30.2
Pacific Gas & Electric, 2001 $29.8
UAL, 2002 $25.2
Adelphia, 2002 $21.5
Believe it or not, this is evidence of a well functioning capital market system cutting off weak borrowers and reallocating capital to efficient, stronger companies – with the well-publicized corporate scandals for many of these companies merely a symptom of the larger economic trend.
Economies need this spring-cleaning as it allows the more solid companies to boost profitability once their inefficient, value-destroying competitors have been weeded out.
This is Adam Smith’s “invisible hand” at work and represents a healthy market process for the long run, though it may seem anything but in the short term. The dead wood must be cleared out before a robust recovery takes place.
The shocking scandals we saw from 2001 to 2003 aren’t such a bad sign either. At least the bad apples were spotted and thrown out. This was a case of a few rotten ones, not a rotten system. Nevertheless, they were appalling and dealt a heavy financial and psychological blow to the U.S. markets.
This has been anything but a normal economic slowdown. Such massive shocks to the system inevitably shot high yield bonds’ interest rates to severe highs in the fall of 2002 (thus causing the bonds’ prices to plummet). Yet this event may serve us well.
The highly respected financial magazine The Economist (January 4, 2003) believes that ” these life-threatening interest rates may have brought matters to a head, helping to bankrupt the worst-offending firms and encouraging the rest to start shaping up.” We couldn’t agree more.
Have Default Rates Peaked?
The saying that “it’s always darkest before dawn” now comes to mind. The wave of mega-bankruptcies from 2001-2003 and nauseating corporate scandals may just be this darkness – with a new dawn approaching for the high yield bond market. Now that a couple of years have passed since the big headlines, and the culprits are being brought to justice, we think the timing is right for a high yield bond bounce. And let’s not make the mistake of confusing debt default rates with equity bankruptcy – the two are not related. In fact, equity woes in the corporate world may be good signs for debt markets.
The repercussions from the 2001-2003 shocks and the longer-than-expected economic slowdown are quite positive for those high yield bond investors just now entering the market: Much of the low-quality high-yield debt used to finance the ephemeral technology and telecom boom of the late 1990s may have finally been purged.
It seems that the corporate-debt binge during the financial bubble is finally starting to clear.
Price Determinates for High Yield Bonds
Since high yield bonds do not offer the same level of protection – compared to U.S. government and, to a lesser degree, investment-grade corporate bonds – company fundamentals (i.e. financial health and operating performance) along with general economic trends matter more than interest rates. That’s because these fundamentals determine whether the issuer has the cash flow wherewithal to keep up with debt obligations.
Although all bonds to one degree or another are affected by the level of interest rates (a bond’s price generally moves inversely to interest rates), company creditworthiness is of much greater importance with these types of bonds.
One important reason why high yield bonds are less sensitive to a rising interest-rate environment is the sizeable interest payments that overshadow a change in rates and the ability of HYB investors to reinvest these fat payouts at the new higher rates. In comparison, the top concern for Treasury investors is the level of interest rates and inflation. Investment-grade corporate bonds fall somewhere in between.
Why the High Yield?
These kinds of bonds offer higher yields to compensate for their credit risk: The bond-rating community considers these bonds as having a higher-than-average probability of defaulting. So the greater the perceived risk, the higher the yield that must be offered to investors. In theory, the higher interest rates paid by these bonds should more than compensate investors for the expected small loss of capital from defaults.
But in bad economic times, such as in the past couple of years, a jump in default rates can significantly eat into the high yields earned by investors. In turn, the heightened risk of default during such economic slowdowns usually results in a fall in high yield bond prices.
Yet during economic recoveries, these bonds can enjoy a stellar performance as capital gainers – fueled by bond prices rising with the improving economic outlook – combine with the fat returns from the high yields collected.
Even in a timid recovery, though, corporate financial conditions can stabilize enough to lower the risk of default. In such a situation, the stock market may end up just treading water while the juicy yields collected from high yield bonds can offer attractive income in the meantime (one of our key reasons for recommending these bonds today).
HYBs can enjoy a further boost if any of the rating agencies, upon reassessment, decide to upgrade the status of a company’s credit rating due to an improvement in its financial health. Even the perception of a possible increase can positively affect a bond’s price.
Overall, high yield bonds can be viewed as medium- to low-risk. They take full advantage of any economic recovery and can even outperform all other asset classes in a merely stable environment, given their high-yielding income. And as previously mentioned, HYBs can produce the kind of double-digit returns often expected from equities – but without the extra risk.
Just as important, HYBs offer low correlation to other asset classes, thus providing excellent diversification in a portfolio. And again, their prices aren’t as sensitive to interest rate hikes as other bonds. In fact, The Oxford Club’s current Asset Allocation Model (as seen below) calls for a 10% exposure to HYBs.
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Yield Spreads: Another Reason Why HYBs Look So Good Now
Last, but certainly not least, we take a look at yield spreads (the difference in interest rates offered on high yield bonds and U.S. Treasuries). Actually, the yield spread may be the main reason for HYB bullishness. Investors became overly jittery over the prospects of the U.S. economy over the past three years, leading to HYBs offering a bigger premium than usual over higher quality bonds. The wider the spread, the more investors are being compensated for risk.
And it appears that the market overreacted. The market’s jumpy response to the 2001-2003 onslaught of mega-bankruptcies and corporate scandals pushed yield spreads to near record highs. As recently as 2002, the Merrill Lynch High-Yield Index widened to a spread of 12 percentage points over Treasuries, a level reminiscent of the record 1990-91 highs that marked the end of that high yield bond bear market. (Historically, the average yield spread for HYBs ranges between 5 and 7 percentage points; and the spread has even dipped below 3 before.)
So we’ve covered our viewpoint of the U.S. economy’s prospects: a gradual economic recovery combined with an improving corporate financial condition.
In light of this, the recent, excessive widening of the spread renders high yield bonds extremely attractive (see the chart below). And it should be noted that while the yields on HYBs are significantly higher than usual, interest rates are at multi-decade lows.
Once it’s clear that default rates are coming down, the spread should narrow. A narrowing spread means price appreciation for HYBs.
Here’s where the impressive gains can be captured: The combined return from a rise in bond prices and the fat yields locked in when the spread was excessively wide.
Since the October 2002 highs, both the default rate and yield spread have begun to come down, which served as the trigger for the more recent rally. We expect this performance to continue.
“Overall, then, it does appear that a corner has been turned,” The Economist (January 4, 2003) declared, “and that the turning point came soon after spreads in the corporate-bond market peaked [in October].” Expect low-risk, double-digit returns in this asset class in the intermediate term.
Our Strategy: A Risk Level for Every Investor
After poring over all the research, we are convinced that investing in high yield bonds is the optimal strategy for taking advantage of the U.S.’s highly unusual economic recovery. So what’s our strategy for capitalizing on this blockbuster asset class? We’ve got two suggestions with varying degrees of risk that should satisfy everyone from the risk-seeker to the risk-averse.
For those seeking diversification, liquidity and professional management, the Debt Strategies Fund (NYSE: DSU) invests in bank loans to both corporations and HYBs. We’ve rated this play as medium-risk due to the leverage employed by this fund, which causes it to be more volatile than average but also higher-yielding. Currently, the fund has a solid yield with dividends paid monthly. Begun in 1998, the fund today has a 30.34 turnover rate and NAV of 7.03 (May 2005).
Our second recommendation, which caters to our risk-averse members, is the Vanguard High-Yield Corporate Fund (VWEHX). This fund is by far the largest of its kind focusing on high yield bonds and has one of the best track records in the industry. The fund is conservatively run and charges a paltry 0.22% expense ratio.
Yield has run recently at 6.95% and shares have traded in a narrow range. For more information on the fund, visit Vanguard’s website at www.vanguard.com or call the company directly at 800.662.7447.
Action to Take: Buy both the Debt Strategies Fund (NYSE: DSU) and the Vanguard High-Yield Corporate Fund (VWEHX). Both are already part of the Oxford Income Portfolio. No trailing stops are necessary here.
Good investing,
The Investment U Research Team
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- Return to Part 1 of our High Yield Bonds white paper.
- View the complete High Yield Bonds report as a .pdf file.
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