As the high-yield “junk bond” market teeters toward defaults, there’s still money to be made in quality investment grade bonds. Here’s where to look

 

In last Monday’s Digest, we warned about dangers in the junk bond market.

For any readers less familiar, a junk bond is a bond that’s riskier than what is called an “investment grade” bond. Specifically, the risk is that the issuing-company will default on its owed interest payments to investors.

Because of this risk of default, investors require a higher yield from junk bonds. This is to offset the greater risk these investors are assuming by lending their money to these risky companies.

Recently, we’ve seen a surge of junk-bond issuances from cash-starved companies, reeling from the Coronavirus.

Highlighting research from Eric Fry, last week’s Digest noted how estimates are pegging 2021 corporate default rates at more than 20%.

If that actually happens, it will be nothing short of staggering.

Eric’s fear is that many investors who read headlines about the Fed buying junk bonds will mistake that as a greenlight for leaping headfirst into risky assets … which may turn out quite badly.

From Eric:

Undoubtedly, many of these investors assume the Fed is providing an implicit guarantee to backstop the high-yield market. They believe the Fed has “de-risked” junk bonds and provided an opportunity to pick up additional risk-free return.

The reality, I predict, is that investors have picked up additional “return-free risk,” to borrow a clever phrase from Jim Grant.

Eric’s bottom-line takeaway was clear: stay away from high-yield junk.

***Now, while there’s growing danger in “junk,” there’s growing opportunity in quality bonds — so says our resident income expert, Neil George

 

As the editor of Profitable Investing, Neil specializes in finding his subscribers big income, whether through high-yielding dividend-stocks, bonds, REITs, MLPs, or more obscure investment vehicles.

Recently, Neil has been eyeing high-quality corporate and municipal bonds. And last week, he updated his subscribers on the opportunities he’s seeing today.

From Neil:

While March brought some massive upheavals to these sectors as plunging stocks brought panic selling of everything in the quest for cash, there’s a lot of value in both of these sectors …

With the market shocks and gyrations in March, the spread between municipal bonds and corporate bond yields over Treasuries has spiked. The last time we had such a spike was during the 2007-2008 financial crisis.

 

Yields for Municipal (White) & Treasuries (Gold) & Spread (Green) — Source: Bloomberg Finance, L.P. & Barclays

 

Yields for Corporates (White) & Treasuries (Gold) & Spread (Green) — Source: Bloomberg Finance, L.P. & Barclays

 

This means there are significant yield opportunities to buy right now. And as both municipal bond and corporate bond prices are down with the yields up, they make for great opportunities for gains as the markets further normalize.

***Taking a page from the Fed’s playbook

 

At this point in his update, Neil directs readers toward the Fed’s massive U.S. corporate and municipal bonds purchases. The purpose of these buys is to stabilize the bond and credit markets, while also driving down yields and credit costs for corporations, municipalities, and other debt issuers.

Back to Neil:

This means both segments and others have a major buyer that underpins prices …

The past has shown how corporates and munis profit with Fed actions. From the end of 2008 through the end of 2019, corporate and municipal bonds generated returns of 103.6% and 72.7%, respectively.

 

Municipal (White) & Corporate (Orange) Bond Indexes Total Return — Source: Bloomberg Finance, L.P. & Barclays

***Backing up, is it safe to be buying corporate and municipal bonds in light of the lurking dangers?

 

After all, if the high-yield market is holding some toxic assets as Eric Fry noted, how easily could that contagion spill over into the investment-grade and municipal markets?

Well, let’s establish some broad historical context as we answer this.

Back to Neil:

Bonds have a history of working for both income and growth. In the U.S., the Bloomberg Barclays U.S. Aggregate Index compiles the overall U.S. bond market. Over the trailing 20 years, it has generated a return of 174.8%.

While a little short of the S&P 500 Index’s return of 199%, it achieved that growth with a lot less drama.

 

Bonds vs. Stocks: US Aggregate (White) & S&P 500 (Orange) Total Return — Source: Bloomberg Finance, L.P.

That’s why I continue to recommend buying bonds and, specifically, U.S. corporate bonds and municipal bonds.

That relatively smooth growth curve, even over turbulent stretches in the market, is hard to argue with. But let’s argue anyway …

As you likely recall, 2008/2009 saw the U.S. economy pushed to the brink of collapse. How did bonds hold up then?

Well, it depends on which bonds you’re talking about.

From MarketWatch:

The number of companies who defaulted on their debt reached a record high in 2009, more than doubling from 2008 as the recession weighed heavily on companies with below-investment grade ratings, according to Standard & Poor’s …

The speculative-grade corporate default rate in the U.S. was 11% at the end of 2009. The investment-grade default rate was 0.34% at the end of 2009, with only five companies defaulting. It was higher in 2008, at 0.73%.

So, even at the worst point in the financial crisis, quality investment grade bonds managed to keep defaults beneath 1%.

Perhaps the easiest head-to-head comparison of investment grade defaults versus junk defaults comes from the Corporate Finance Institute:

Historically, investment-grade bonds witness a low default rate compared to non-investment grade bonds.

For example, S&P Global reported that the highest one-year default rate for AAA, AA, A, and BBB-rated bonds (investment-grade bonds) were 0%, 0.38%, 0.39%, and 1.02%, respectively.

It can be contrasted with the maximum one-year default rate for BB, B, and CCC/C-rated bonds (non-investment-grade bonds) of 4.22%, 13.84%, and 49.28%, respectively.

Bottom-line: stick with quality.

***So, what quality bonds are Neil looking at?

 

As always, a huge thanks to Neil for generously giving away so many of his best ideas to our broad Digest file.

Here he is with his investment grade corporate bond fund ideas:

Two bond funds to buy right now include the BlackRock Credit Allocation Income Trust (BTZ) and the Vanguard Intermediate-Term Corporate Bond ETF (VCIT).

Both have impressive collections of U.S. corporate bonds, with BlackRock actively managing the actual bonds, while Vanguard does it synthetically following the BlackRock & Barclays Index. And remember, BlackRock is under contract with the Fed to oversee bond buying …

VCIT yields 2.9% and is a buy in a tax-free account.

BTZ is a closed-end fund and trades at a discount to net asset value (NAV) now of 6.9%, making for an even bigger bargain. Yielding 7.8%, BTZ is a buy in a tax-free account.

And here are Neil’s thoughts on munis:

I also have a collection of municipal bond funds within the portfolios of Profitable Investing, including the BlackRock Municipal Income Trust II (BLE), which is at a discount to NAV. It sports a taxable equivalent yield of 8.2% and is a buy in a taxable account.

Another one of my favorite bond ETFs is the Nuveen Bloomberg Barclays Municipal Bond ETF (TFI). It yields a taxable equivalent 3.1% and tracks the leading muni index. TFI is a buy in a taxable account.

Wrapping up, there’s money to be made in bonds — but there are also landmines to avoid. If you’re thinking about wading into the sector in today, make sure you stick with quality.

Have a good evening,

Jeff Remsburg