Tag Archives: High Yield Bonds

The Other Face Of Risk – Bonds

Usually, when it’s a good time to own high quality intermediate term bonds – those that serve as workhorses of most investors’ portfolios, it’s a bad time to own “high yield” (a nice marketing term for “junk”) bonds, and vice versa. That’s because lower interest rates provide a good climate for relatively safe bonds that don’t deliver much yield, and because the economic weakness that low rates signal is often a danger to shaky borrowers.

Conversely, the rising rates that can inflict duration-related damage to safer, lower yielding bonds usually coincide with a robust economy that’s good for junk bonds. So it’s not often that the climate is good or bad for both high-quality intermediate term bonds and high yielding junk bonds.

But, in a note to its investors, the Los Angeles-based value investment firm FPA Funds has just argued that the current environment is bad for both the typical portfolio bond workhorses and more exotic high yielding fare. First, there is a disagreement between the yield curve and the implied inflation that the 10-Year TIPS bond is signaling. The yield curve is flat, implying that investors anticipate deflation. After all, the only reason an investor in longer term bonds would accept a marginally higher yield over a shorter term bond is if the investor anticipates deflation and lower rates in the future. However, that seems unlikely to FPA New Income Fund (FPNIX) portfolio managers Thomas Atteberry and Abhijeet Patwardhan and FPA product specialist Ryan Leggio, since the difference in yield between the 10-year TIPS bond and the 10-Year Treasury is around 2 percentage points now, indicating an anticipation of 2% inflation.

But if inflation – or at least some tepid alternative to deflation – is on the horizon, doesn’t that mean that it’s a good environment for junk bonds? Not so fast say Atteberry, Patwardhan, and Leggio. The high yield “spread” – the difference in yield between high yielding corporate bonds and Treasuries – is very low. That means investors aren’t getting paid much to take the credit risk of owning high yield bonds. That’s especially true since leverage is high among corporate borrowers and covenant quality levels are low. A covenant is a legally binding agreement between borrowers and lenders designed to protect the interests of both parties. Low covenant quality means borrowers don’t have to meet specific requirements.

The authors note that “this is only the third time in the past twenty years when the yield curve has been this flat while at the same time high yield spreads have been this tight.” The upshot of their analysis is that it’s a good time for bond investors to reduce both credit and duration risks. The FPA New Income fund, accordingly, has a short duration, and is reducing credit risk. The fund is avoiding unsecured corporate bonds, and favors secured bonds, for example. It has around 8% of its portfolio in corporate bonds overall compared to 31% and 39%, respectively for funds in the Morningstar Intermediate-Term  Bond and Short-Term Bond Fund categories. As an alternative the fund prefers highly rated asset-backed securities which absorb 57% of its assets. Altogether, 71% of the fund’s assets are in AAA-rated securities.

FPA New Income has always been a “belt-and-suspenders” bond fund from the time legendary investor Bob Rodriguez ran it. It’s managers dislike posting negative return numbers. This has caused them to miss some rallies in bonds. For example, the fund has posted a 2.04% annualized return for the past decade ending in February 2018, while the Bloomberg Barclays US Aggregate Index has delivered a 3.60% annualized return over that time. But the fund’s willingness to “shoot only in a target rich environment” also means it has kept investors safe since 1984, including a 4.31% return during the financial crisis year of 2008 when so many bond funds missed the credit problems of their holdings and faltered as a result. Also, besides never posting a negative return in a calendar year since inception, over the 30 year period ending in February 2018, the fund achieved a 5.85% annualized return versus the 6.13% annualized return of the index. Ten years is a long time, but it’s worth considering whether the fund’s underperformance over the last decade indicates more alarming things about the prevailing credit and interest rate conditions than about its approach.

The Dumbest Bet in Finance

In this past weekend’s Real Investment Advice Newsletter, I wrote about financial advisor Larry Swedroe’s excellent article on the “Four Horsemen of the Retirement Apocalypse:”

  • low stock returns,
  • low bond yields.
  • increased longevity; and,
  • higher healthcare expenses.

In his article, Swedroe mentions that high yield (junk) bonds won’t save investors, who haven’t historically been rewarded well for taking on their risk.  Swedroe also says high yield bonds correlate well with stocks, which means they don’t provide much diversification.  Swedroe writes from the point of view of modern portfolio theory, which looks for ways to increase volatility-adjusted returns in a portfolio. In this post, I’ll treat junk bonds a little differently, showing why now is a terrible time to own them. My analysis doesn’t completely contradict Swedroe’s though; it supports his thesis that stocks and junk bonds are highly correlated.

Unlike Swedroe, I don’t dislike junk bonds per se. These loans to decidedly less-than-blue-chip companies are just like any other asset class. They can be priced to deliver good returns, as they were in early 2009, or not.

Right now, they’re not.

Everyone looks at junk bonds initially by observing the starting yield or yield-to-maturity. Right now, the iShares High Yield Corporate Bond ETF (HYG) is yielding 5.53%. That can look attractive to some investors. After all, where else can you get over 5%?

Other people look at the spread to the 10-Year U.S. Treasury. 5.53% is around 2.7 percentage points more than the 2.8% yield of the 10-year U.S. Treasury. That might look find to some too. Of course, a little bit of research shows that spread is lower than the historical average of around 5.7 percentage points.

Still, investors seeking higher yield may be undisturbed by a historically low spread. Some people need the extra yield pick-up over Treasuries, however small it might be by historical standards, and that’s enough for them to make the investment.

Yield Isn’t Total Return

There’s one extra bit of analysis, however, that should make investors think again about owning junk bonds – a loss-adjusted spread. The problem high yield investors often fail to consider is that junk bonds default. And that means the yield spread over Treasuries isn’t an accurate representation of what high yield investors will make in total return over Treasuries. It’s easy to forget about defaults and total return because defaults don’t occur regularly. They tend to happen all at once, giving junk bonds a kind of cycle and encouraging complacency among yield-starved investors during calm parts of the cycle.

Default rates for junk average about 4.2% annually, according to research from Standard & Poor’s. And investors have typically recovered 41% (or lost a total of 59%) of those defaults, according to this Moody’s study from 1981 through 2008. That results in an annual loss rate for an entire portfolio of around 2.5%. So the iShares fund’s 5.53% yield isn’t quite what it seems to be. In fact, if we subtract 2.5 from 5.53, the result is 3.03, meaning investors in junk bonds are likely to make only 20 basis points more than the 2.8% they could capture in a 10-Year U.S Treasury currently.

Now, a more careful analysis should consider an “option-adjusted” spread, which accounts for the fact that issuers can call bonds prior to maturity and lenders or bondholders can sell bonds back to the issuer at prearranged dates. This adjustment usually adds something to the spread, making higher yielding bonds slightly more attractive. So we took the options adjusted spread data, and adjusted it for an annual loss rate of 2.5 percentage points. Remarkably, there have been times such as immediately before the financial crisis when investors weren’t making anything on an options-adjusted basis above Treasuries to own junk bonds. Now at least it’s around 1 percentage point.

 

Still, even with the option adjustment, one percentage point over Treasuries is still very little, especially considering that the option-adjusted spread we used compares a junk bond index with Treasuries. In other words, the 0.50% expense ratio of most junk bond ETFs isn’t factored into the equation. At a 0.50% or so yield pickup over Treasuries, investors just aren’t making enough from junk bonds to justify owning them. Also, advisors pushing junk bonds on yield-hungry clients aren’t doing much due diligence. The mark of a good advisor is one who can say “No” to a client and bear the risk that the client will go to another advisor doing less due diligence.