A Better Way to Invest in High Yield Bonds

High yield bonds, or “junk bonds” as they are sometimes referred to, are an integral part of corporate finance. This form of debt is typically issued by corporations deemed to have a higher risk of default. To compensate, the yields on these bonds are typically much higher than investment grade corporate bonds. This paper discusses the basics of high yield bonds and their potential benefits for suitable investors which, in many cases, may offset the inherent additional risks associated with these investments. For instance, high yield bonds tend to be less influenced by changing interest rates than their higher-grad counterparts. Instead, high yield bonds are usually more influenced by economic factors affecting the issuing corporation and economy as a whole. High yield bonds also offer the potential for capital gains (or losses) in addition to the stated coupon yield. These characteristics can make high yield bonds an attractive addition to a diversified portfolio, especially when used in conjunction with a trading system that seeks to minimize the risk of loss during downward price fluctuations.

 

 

High yield bonds have been around for longer than most of us can remember. Anybody who was born earlier than 1960 can recall the days of Ivan Boesky and Michael Milken, the highly creative and somewhat dubious creators of “junk bonds” (the more-to-the-point term for high yield bonds). Eventually, their actions, not the junk bonds, landed the boys in jail for a short time. It should be noted that never was there (then or now) anything illegal about the use of the junk bonds, but their criminal activity, in part, contributed to the bad reputation sometimes attributed to high yield bonds.

 

In this paper, the terms high yield bonds, junk bonds, and “junks” will be used interchangeably and will have the same meaning and reference. These terms apply to loans that are made to higher risk, corporate borrowers of money. High yield bonds had been in existence long before Boesky’s and Milken’s involvement in the early 1980s. During the early part of the 20^th century General Motors, U.S. Steel, and other well-known corporations borrowed money that, at that time, was considered higher-risk debt. If that debt were issued today, it would be considered to be a junk bond. 

 

Fast forward to today and we find that more than $500 billion (a half-trillion dollars) defines the magnitude of the high yield bond market. Its explosive growth is the result of two factors: 1) more companies needing capital; and 2) the availability of investors who are willing to take more risk in return for a higher yield on their investment.

 

Bonds are rated based on the probability of the borrower defaulting on the bond, that is eventually failing to meet the terms of the bond covenant. The highest quality bonds, those with the greatest probability of paying back the loan principal and interest, are rated AAA. As the chances of a bond default increase, the rating on the bond decreases, as illustrated in Table 1, below.

 

 

Standard & Poor’s Rating	Grade	Default Risk
AAA	Investment	Lowest Risk
AA	Investment	Low Risk
A	Investment	Low Risk
BBB	Investment	Medium Risk
BB, B	Junk	High Risk
CCC, CC, C	Junk	Highest Risk
D	Junk	In Default

 

 

 

Therefore, we can see that the two terms used to describe these bonds, high yield and junk, come from two features of the bonds: 1) High yield refers to the increased interest rate that accompanies the bonds; and 2) Junk refers to the low quality of the bond.

 

In 2007, investors and the public became intimately familiar with sub-prime consumer mortgages and their risk to lenders (and ultimately the economy, in general). The actions of consumers overextending themselves by borrowing more debt than they could repay, under terms that were unfavorable, eventually resulted in a near-collapse of the consumer mortgage market. Investors in those sub-prime mortgages soon found their investments suffering tremendous losses. Meanwhile, the ability to sell out of those investments became more and more difficult due to a lack of buyers. A similar scenario also played out in the high yield bond market in which holders of low-quality debt saw their investments lose a substantial percentage of its original value.

 

It’s a fact of life that consumers with low credit scores must pay high interest rates when they borrow money. This higher interest rate compensates the lender for the increased chance of the borrower defaulting on the loan. Likewise, corporate borrowers with a lower credit rating have an increased probability of defaulting on their loans and pay lenders accordingly. Those who lend money to these corporate borrowers demand compensation for the extra risk they take in making these loans. Should a default occur, the bondholders stand in line with all the other creditors of the company, hoping to get back some portion of their money. The lower the quality the bond, the less chance there will be assets that can be used to pay back creditors. The increased interest rate compensates the lender, at least in part, for this additional risk.

 

The result is that those entities that lend money to higher risk borrowers, via junk bond offerings, receive a higher interest rate than if they had been lending money to higher quality (lower risk) borrowers. To illustrate this difference, consider that over the past twenty or so years, high yield bonds have paid an interest rate of 3-9% (with an average of 6%) per year more than that of U.S. Treasury bonds. This difference is known as the “spread.”  In early 2008 the average default rate on junk bonds was about 1.1%.  However, as the economy continued to sour, the default rate was expected to increase to around 5.2%. Compare this with an average, long-term default rate of about 4.9% (according to John Lonski, chief economist of Moody’s.)

 

An additional risk of junk bonds is their lack of liquidity. Liquidity refers to the ease of trading the instrument in the marketplace. The author of this paper also refers to liquidity as “how quickly one can sell an investment and convert it to cash”. Junk bonds are not traded as freely as, say, government bonds. Thus, the liquidity of high yields is significantly lower than that of high quality debt, which leads to higher costs of trading and selling at one’s desired price. All of these factors combined result in the higher interest rate that is attached to junks.

 

 

Unlike normal bonds that are greatly influenced by fluctuations in interest rates, junk bonds are less affected by interest rate movement. This is because junks generally have higher interest rates and have, typically, shorter maturities. In fact, junk bonds are affected more by overall economic changes (expansion or contraction) than changes (increase or decrease) in prevailing interest rates. This is because the quality of a junk bond is most affected by the strength of the company issuing the bond.

 

If the company’s profitability increases (since the issuance date of the bond), the quality of their bonds increases. For an investor in a junk bond, this is an almost-perfect scenario, one in which a junk bond with a high interest rate becomes a quality bond with a high interest rate (this being the result of the formerly high risk borrower becoming a low risk borrower). 

 

For example, ABC Corp. had a debt rating of “B” and issued a bond at 12%. Meanwhile, AAA-rated debt was paying 4%. Sometime following issuance of this debt, ABC Corp. enjoys a return to profitability and its debt rating is upgraded to “A”. The result is that holders of those old ABC Corp. bonds now hold A-rated debt that is paying 12%! This, in turn, makes the underlying bond more valuable (with the price of the bond potentially rising) since investors are willing to accept a lower rate of interest on debt issued by a stable company.

 

In our opinion, investing directly in individual junk bonds should be left to the wealthy and institutional investors. In fact, the majority of investors in junk debt are institutional…mutual funds, pension funds, hedge funds, and others. This, however, does not suggest that investing in junks is only for the wealthy. Most all investors can get an exposure to junk bonds by investing in mutual funds that specialize in them. 

 

By investing in a mutual fund that specializes in junk bonds, an investor can take advantage of a professional fund manager. Additionally, the investor will be able to reduce (but not eliminate) risk via the diversification that mutual funds offer. (A typical mutual fund will hold as many as 200-400 bonds, all of which are owned, on a pro rata basis, by investors in the fund.)

 

Keep in mind, though, that investing in a mutual fund does not mean that the investor has no risk. Like the bonds held by the fund, a mutual fund can gain or lose value.   

 

In the event of a slowing economy, high yield bond mutual funds can lose significant value. So, for anybody considering an investment in high yield bond funds (or for that matter, any mutual fund) consider your tolerance for and ability to withstand potential losses. 

 

As much as we, at Sojourn, really like investing in high yield bond funds, they have one major flaw. That flaw is that there are times in which high yield bonds (and mutual funds investing in them) will get absolutely annihilated in a bear market. The years 2007 and 2008 are the most recent examples of this. In 2008, the majority of high yield bond mutual funds lost more than 20% of their value. Worse still were those funds that lost more than 50% of their value.

 

Let's consider the actual performance of a popular, well-known high yield bond mutual fund. We selected this fund for no reason other than to illustrate the extent to which some high yield bond funds can fall in price. This is the investment experience that “buy-and-hold” investors would realize if they had been invested in this fund:

 

From its highest price ($5.80 per share) on May 31, 2007 to its lowest price ($1.24 per share) on November 20, 2008, this high yield bond fund lost about 78% of its value! (Please note that we have selected this mutual fund only because of its dramatic price change. Our selection of this fund does not make any statement, positive or negative, about its potential value as an investment.)

 

If losing 78% weren’t bad enough, consider that investors who held their shares of this high yield bond fund would need to realize a price appreciation of 367% (a gain in price from the low of $1.24 to the former high of $5.80) to return to the highest value of their investment in May 2007! This is an extreme example of what can happen to buy-and-hold investors, but remember, this is an actual example of what can, and did, happen to a real high yield bond mutual fund.

 

Risk-averse investors may find themselves asking, “Is there a way to invest in high yield bond funds with less potential risk of losing money in a down market?” Fortunately, the answer is, “Yes, there is.” There exists any number of advisors who actively manage money for their clients. (The author of this paper, and his firm, are among those who manage money for investors who want to invest in high yield bond funds.) The goal for most of these advisors/managers is to be invested in a security/market when it is gaining in price and to sell that security/market before its price goes down too much. When the price of a security (in this example, a mutual fund) is expected to fall substantially in price, the active advisor will, most often, sell his clients’ shares of the mutual fund and purchase shares of a money market fund. In doing so, the advisor’s objective is to insulate the investors from further price declines that would erode the value of the clients’ investments.

 

If an advisor were able to do this buying and selling successfully (and we emphasize “IF”), then that advisor’s clients/investors would potentially be able to make more profit while taking less risk. By reducing the losses during those (time) periods in which high yield bonds have experienced significant losses (1998-2002 and 2007-2008), an investor can dramatically improve potential, long-term profits.

 

We’ve spent considerable time discussing the importance of the timely selling of a mutual fund, in order to avoid losses. But, the other side of story is the timely purchase of a mutual fund. Good money managers and good investment advisors are not just successful at buying or just successful at selling. Good money managers and good investment advisors are successful at BOTH buying and selling.     

 

We, personally, are aware of a limited number of managers who are good at either buying or selling, but not both. Without intending or appearing to brag, we consider ourselves among those relative few who are able to successfully buy and sell high yield bond funds at opportune times. Keep in mind, neither we nor any honest advisor, can or will guarantee that a trading strategy will continue to function favorably in the future (refer to our disclaimer at the end of this paper).

 

At this point, readers of this paper are either eager to invest in high yield bond funds or skeptical and not interested in the increased risk. For those who are tempted to invest in the high yield bond market, a question arises: “How much profit is left after the big run junks had in 2009?”

 

It goes without saying that we have no idea how much more high yields can offer. However, we can offer a look at three possible scenarios:

 

If the economy continues to improve, profits of most corporations will rise. At the same time, we would expect profits of many issuers of high yield debt to improve. If this scenario does, in fact, occur then we would expect high yield bonds to continue increasing in price. (Additionally, bondholders would continue to receive interest payments from those bonds.)

If the economy begins to worsen, then corporate profits will likely be depressed. At the same time, profits of issuers of high yield debt would probably suffer. In this scenario, the prices of high yield debt would probably begin to fall. The buy-and-hold investor would suffer losses to his/her investment. Investors who use skilled, successful active managers have a greater probability that their advisor/manager would sell their junk bond funds and invest their money in the safety of a money market fund. This move to safety would help preserve the value of investors’ money.

 

If the economy becomes listless and neither grows nor contacts, there is the possibility that high yield bond prices could stagnate. That is, prices would neither rise nor fall. It would be extremely rare for this to continue for an extended period of time, but let’s assume it does. In such a situation, the investor would likely neither gain nor lose money on his/her investment principal. However, he/she could continue to reap profits in the form of high interest income being generated by the bonds.

 

So, looking at the three possible scenarios, the only one that we would expect to pose a threat of significant loss is Scenario #2 for, specifically, the buy-and-hold investor. The investor who uses a skilled, active advisor/manager has a significantly greater chance of avoiding losses during a “down market”.

 

 

In summary, we contend that high yield bond mutual funds can be an extremely attractive way to invest, though subject to substantial losses during falling markets. Furthermore, we believe that investing in high yield bond mutual funds can be an even more attractive method of investing, if managed under the guidance, direction, and oversight of an experienced and skilled investment advisor who has shown the ability to successfully buy and sell high yield bond funds at opportune times.  While no advisor, including this author, can guarantee that a trading strategy will continue to function favorably in the future, it appears that trading strategies do exist that have historically performed well in real-time trading environments.

 

 

1.  Glenn Yago. “Junk Bonds.” The Concise Encyclopedia of Economics. 2008. Library of

      Economics and Liberty. Retrieved December 20, 2008 from the World Wide Web:

      http://www.econlib.org/Library/Enc/JunkBonds.html

 

2.  John Waggoner. USA Today. February 7, 2008.

 

3.  “Junk Bonds: Everything You Need to Know.” Investopedia^®

 

4.  Morningstar^® Principia^®.

 

 

Sojourn Financial Strategies, LLC is a registered investment advisor, registered with the State of Ohio. A decision to invest should not be based on theories, graphs and/or charts; a decision to invest involves risk and may include the loss of principal. 

 

Indices utilized herein are for comparative purposes only and are not intended to parallel the risk, volatility or investment methodology of the various strategies offered by Sojourn Financial Strategies, LLC. Under no circumstances should it be assumed that recommendations made in the past or the future will be profitable or will equal past performance. All investments involve risk of financial loss.

 

Presentations and examples made herein represent a strategy that has been used in actual trading by the author. The analysis and commentary contained herein are provided “as is” without any warranty of any kind, either expressed or implied. 

 

Information contained herein is intended for informational purposes only and is not a recommendation to buy or sell any security or investment strategy, nor is it intended as specific advice for any investor’s portfolio. 

 

All advice is impersonal in nature. 

 

Sojourn Financial Strategies, LLC is not a broker/dealer.