Asking a stock guy about the junk bond market is like asking a Spaniard if he understands Portuguese. A Spaniard kind of does, but not with all the details. So when I was asked to give my take on junk bonds, I decided to look up a real expert.
I found one in Mike Lanier of Silver Oak Asset Management. He has dealt in junk bonds for a couple of decades, including for some of the nation’s largest financial institutions. When asked if junk bonds are overpriced, he took an hour to answer — and we probably only scratched the surface. His response: “yes” and “no.”
Junk bonds look expensive on an absolute basis. The benchmark BofA Merill Lynch US High-Yield Master II Effective Yield index (red line in the chart below) is near its all-time low in yield (it hit that mark of 6.81% on May 16, 2011). Still, “where else are you going to get something that yields close to 7%?” Mike asked.
I was aware of this issue. I have had to kick the tires on several utilities and master limited partnerships in the past month and had seen that in every case they were yielding substantially below their five-year averages. The average yield of an S&P 500 utility was 4.32% with a payout ratio of 66.1%. There were a few odd-ball telecoms in the S&P 500 with higher yields, but junk bonds were pretty much it when it comes to higher yields.
Given the situation in the Treasury market, Mike thought it still was a great idea to invest in dividend stocks with sustainable payouts because they have the ability to increase their dividends. Bonds (usually) cannot increase their coupon payments. (Inflation-indexed bonds can, but they’re a small part of the overall Treasury market and not nearly as popular in corporate bond land.)
But bonds aren’t meant to. They’re about return of capital, while stocks are about return on capital. Bondholders lend, and shareholders own. Those are two very different parts of the capital structure. Mike has seen plenty of cases where the stock guys thought a company’s stock was a great deal, while bond investors looking at the same company thought its bonds were terrible investments.
Since the Federal Reserve has chased yield-seeking investors from the Treasury market, they can get junk bonds now with “not-all-that-much duration risk,” Mike said. The yield on a 30-year Treasury is now 3.08%. Mike continued: “If long-term Treasury rates normalize, you can get killed holding long-term Treasury bonds as prices will decline dramatically.” But intermediate-term junk bonds don’t have that problem. “The duration risk is not high,” he pointed out, “and they can handle a rise in Treasury yields if/when it comes.”
This is because the yield spread between Treasuries and junk bonds isn’t nearly as tight as it was five years ago. Currently, that yield spread is 6.01% (blue line in the above chart) — or 601 basis points (bond people tend to convert everything to basis points). The all-time low spread was on June 1, 2007, at 2.41%.
If U.S. GDP growth accelerates to above 3%, it will be entirely possible to see Treasuries sell off and see their yields rise, while junk bonds can rally at the same time and see their yields fall, pushing the Treasury-junk spread toward historic lows.
I told Mike I noticed a strong correlation between the prices of junk bond ETFs like the SPDR Barclays Capital High Yield Bond ETF (NYSEARCA:JNK) and the S&P 500. “It makes sense,” he said. “Junk bonds love a strong economy, and so do stocks. Treasuries love a weak one.”
He went on to say it’s always a good idea to remind people of the cliff you fall off when junk bonds go down. It’s one of the main reasons they pay so much the rest of the time. High-yield debt is far more volatile than all the investment-grade alternative fixed-income choices when it comes to general economic slowdowns, especially true recessions.
At the same time, high yield is much more insensitive to interest rate swings. This matters for small investors who take on a high-yield bet in their investment accounts because when stocks are getting hit by a potential slowdown in the economy, their other bond investments will be trading up as interest rates fall — while their high-yield bonds could be off as much as the stock market. In short, said Mike: “Reads like bonds, but trades like stocks.”
“A great sign that the junk bond market is out of control is when you see dividend deals,” he said. I had never heard of a “dividend deal” before. He explained: It’s when a company that had been in a leveraged buyout (LBO) issues junk bonds to pay off the LBO buyers. Everyone knows that this is a bad deal, he said, because such LBO junk is priced to yield higher than comparable-rated bonds, and yet because there is hot money moving in the bond market, these deals still get done.
It currently is a seller’s market due to the funds flowing into the sector. He said he’s seeing more and more telltale dividend deals as well as “covenant-lite” deals (high-yield deals with investment-grade-looking covenant packages). But, he added, “We are not seeing those to the extent of excesses of the past, but the most since the recession, and the trend is rising.”
Is that a point of worry? “Yes, in that these deals typically have even more downside risk than average in a downturn. If we avoid a double dip and actually begin a real recovery, they will have little impact on results.”
Ivan Martchev is a research consultant with institutional money manager Navellier and Associates. The opinions expressed are his own. This is neither a recommendation to buy nor sell the investments mentioned in this article. Investors should consult their financial adviser prior to making any decision to buy or sell any above mentioned securities.