To Watch: Low-quality Bond Funds

Given the credit problems and the widening of the junk bond spread (over Treasury bonds), I think a good contrarian area to watch are credit investments. Aaron Pressman's BusinessWeek blog postings (here and here) talks about potential opportunities in low-quality debt instruments. It's illuminating to read the older blog entry and see how much things have fallen since then. Anyone who thought these instruments were attractive in July has lost quite a bit in one month.


To refresh your memory, the amount of extra yield over Treasury bonds that junk investors demanded leaped from a record low of less than 2.5 percentage points in early June to over 4.5 points in recent days


I personally think that this spread will widen even further. All this widening is occurring without any material slowdown in the economy. If corporate profit growth, which I view as near a peak, starts slowing down then low-quality corporate bonds will correct even further. Some of the corporations that issued junk bonds may have difficulties paying. That is the ideal time to buy! Right now, only the mortgage-related bonds have corrected to any meaningful degree.

The funds mentioned in the blog entries that interest me are:
  • Regions Morgan Keegan Strategic Income Fund (RSF)
  • RMK Multi-sector High Income Fund (RHY)
  • iShares iBoxx High Yield Corporate Bond exchange-traded fund (HYG)

The first two hold CDOs and mortgage bonds, which are precisely the ones that are suffering these days. The following NAV chart of RSF shows how it has dropped off a cliff lately.


(source: etfconnect.com)


Interestingly, even with a big correction, the RSF is trading at a premium to NAV. I think something like this is worth checking out in a few months. I suspect that it will keep dropping further as the mortgage debt issues, in addition to a possibly declining stock market, re-price these funds.

There are a whole hoard of other CEFs that one should investigate if they are interested. The advantage of CEFs is that they can possibly be bought at discounts. One can never be sure if the discounts will dissapear (thus profitting someone who bought with a discount) but in the long run it isn't a bad bet. One thing to note with CEFs is that they may have high MERs (management expense ratio). I haven't looked into any of these in detail (since we are nowhere near a bottom) but if MER is 2.5% and, say, the yield is 8%, then you are paying 30% of the income in costs--a huge cost. In such cases, I will only find the funds attractive if capital gains potential is much larger (or the yield is way beyond 10%).

Of course, the ideal solution, with the highest payoff (and also the highest risk) is to directly buy the corporate bonds or CDOs instead of using one of these funds. You avoid all the fund expenses but have to pick the right one. Since I'm in Canada and I have a small portfolio, this isn't easy for me. However I will consider exchange traded bonds on NYSE.


So to sum up, I'll watch the situation and consider investing in the future (maybe 5 or 6 months from now). I think a good time to consider junk bonds are when the economy troughs, and the yields are more than 15% (or yields of around 10% with a sizeable capital gains potential).

UPDATE: I think emerging market bond funds are also worth looking into. Unlike the Street, I think EM debt is still too expensive. The market is not pricing in the risk of default. If, and when, the market discounts the EM debt, it may be attractive. An example of an EM CEF is the recently launched Morgan Stanley Emerging Markets Domestic Debt Fund (EDD). Before diving into these, one needs to check to see how currency fluctuations will impact these bonds. I will consider EM debt funds in 6 months or so (or if the market sells off EM debt).

UPDATE: A few more CEFs with subprime exposure to consider in the future (courtesy some poster on the M* CEF message board): RMH, RMA, FHI, FHY, FHO

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