False Start In The Bond Market?

Today’s WSJ has this quote in their “Financial Flashback” section but possibly describing today’s conditions:

“Some savvy bond investors are raising money that they plan to use to snap up distressed debt. Trouble is, there isn’t a lot to snap up. An argument can be made that the smart money is too early this time. (Jan 20 1997)”

In the past few weeks, a steady stream of pundits (including me) has been pointing out attractive opportunities in the bond market ex-Treasuries and now, in these markets from TIPS to junk, prices have recovered somewhat.  Investors may have gotten a bit ahead of themselves yet again.

One indication suggests investors may be overly enthusiastic in playing the junk bond market. iShares has a junk bond ETF (its official title is the iShares iBoxx $ High Yield Corporate Bond Fund; ticker HYG).  According to ETFConnect, as of 01/16/2009, HYG was selling at 3.4% premium and yielding 8.35% with no leverage.  Compare this to the Merrill Lynch High Yield 100 yielding 12.156% at the end of last week.  HYG’s yield is less than 200bp higher than the broad DJ Corporate yield at 6.417%.

A more attractive vehicle would be the SPDR Lehman High Yield Bond ETF (with its appropriate ticker, JNK). This ETF also trades at a 3% premium during the media-led runup but its 14% yield is much more appropriate for anything called “high yield”.

According to this Journal article, Moody’s pegged the corporate default rate at 4% at the end of 2008.  This rate is expected to increase to 15% by YE 2009, far higher than the 12% peak in 1991. It’s possible that the worst of the credit dislocation is behind us but I agree with those assessments which posit that it will be hard for corporate junk to continue to rally in the face of rising defaults.

Investors should be aware of the risks looming in this area and demand appropriate compensation.  Previous dislocations (1991 & 2002) suggest investors should demand junk spreads no less than 1000 bp.  The current crisis is far more severe than either of those occasions so you may wish to adjust the premium accordingly.

Also, it may be possible that new investment instruments (ETFs, etc.), spurred by retail interest as the media reports of bargains in junk bonds, have accounted for some of the recent rally.  If so, these investors may be less likely to hold on to their ETFs in the face of a falling S&P 500 and the bonds may fall again without that support.  After all, ETFs lack the inherent catalyst provided by a maturity date so falling quotes may affect those investors more.

In any case, 8.4% seems inadequate for junk bonds as investors can find safer investment-grade debt while sacrificing only a little yield.  As recently as this morning, investors can find 3-year debt issued by government-assisted banks (C, BAC, MS) yielding anywhere from 5% – 7%.   If the financials are too scary, you can buy telecom or utility debt with yields from 5% – 8%.

As always, YMMV.

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One Response to “False Start In The Bond Market?”

  1. The Enlightened American » Portfolio Performance +2.1% Through February 2009 Says:

    [...] not to discuss these securities or the underlying companies on this blog. Generally speaking, while I believe the mad rush into corporate bonds may be somewhat premature, I have poked a toe into a few positions. The junk bond spreads are at record levels on both a [...]

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