Sunday, April 20, 2008 2 comments ++[ CLICK TO COMMENT ]++

When Is It Worth Investing in High Yield Bonds?

A question for my readers...

Does it make sense to invest in extremely long-term high yield bonds rather than stocks? Let's assume risk, and other qualities are similar between the stock and the bond (since this is junk bond, it is almost like a stock anyway). I'm just wondering about yield on a bond versus stock. For instance, would it ever make sense to invest in a 35 year bond with a yield of 13%?

Investing in bonds is generally a bad idea because bonds pay fixed coupons whereas the returns from stocks increase over time. For example, a stock with a 3% dividend yield with a 10% growth in dividends per year will result in a dividend of 10.3% (on the original cost basis) in 14 years. The biggest enemy of long-term bonds is inflation but junk bonds have a relatively high yield so they are somewhat compensated. So does it ever make sense to invest in long-term junk bonds?

I'm not sure how to answer this question based on superinvestors' actions. Warren Buffett likes convertible bonds and he is more than willing to buy 10+ year convertibles with a yield of 10% if he thinks it is low risk (eg. Salomon, Gillette). He also has bought junk bonds if the duration is relatively short (eg. Amazon, Level 3 Communications). So the impression I get is that Buffett would not invest in a long-term bond but would invest in short-term junk bonds or long-term convertible bonds.

If I look at someone like Martin Whitman, he invests in long-term junk bonds. However, Martin Whitman invests in the bonds in a distress situation, often hoping to gain equity ownership in a restructured firm. He does, nevertheless, invest in long-term bonds if the yield is high. Most recently he has invested in MBIA, a monoline bond insurer, surplus notes (around 15% yield) and Standard Pacific, a homebuilder, long-term bonds (around 20% yield). So my opinion is that Whitman buys long-term bonds that have 15%+ yields.

I'm contemplating investing in a 35 yr high yield bond with around 13% to 15% yield (haven't made a decision yet). Does it make sense? Ignore default risk since I'm primarily thinking of whether a bond in general makes sense rather than the stock. Any thoughts?

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2 Response to When Is It Worth Investing in High Yield Bonds?

April 20, 2008 at 3:44 PM

You need to differentiate between junk bonds. One type is the bonds issued by highly leveraged institutions, the "junk bonds" of the Michael Milken era. They are issued at par with 10%+ yields. Often, these bonds are issued in conjunction with LBO's, restructuring, etc.

The other type is a distressed bond. The type that Buffett has purchased in the past(Level 3 Bonds) have had high current yields due to distress. In many cases, these bonds act much like equity. I'll give you an example:

Company D issues $100m par value bonds at 6%, rated AA. Thus, if you invest $1000 in these bonds, you receive $60 per year.
You decide 6% isn't enough, and don't invest. In due time Company D hits a bump in the road, and their solvency and cash flow comes into question. Thus, the bonds which had traded in a range of 98-102 suddenly plunge to 50. The yield on the bonds is now 12% instead of 6%, thus if you invested $1000, you would receive $120 per year, and your bonds are valued at .50 on the dollar. You believe, due to what ever reasons, that the bonds are worth full value as the company will survive. A year later, the company is still around, and cash flow has recovered. Bankruptcy rumors are gone. The bonds now rise to 100, because the company is believed to be solvent. Your return on investment is 112%, as your initial $1000 investment is now worth $2000, plus you received $120 in coupon payments.

So, as you see, the distressed bonds can act much like equity in the right situations. The key is to finding these fallen bonds that will survive, or if they hit bankruptcy, will be paid in full. I believe there is money to be made here, but more money to be lost. So we have to be careful.

April 21, 2008 at 10:27 AM

Thanks for the insightful comment Jeff. I am primarily looking at distressed bonds. Apart from default risk (if there was a high pobability of default or bankruptcy I wouldn't invest--unless recovery value is likely high), my main concern is with the long maturity of the bonds. I think soemthing that matures in 10 or 15 years isn't risky (assuming you are confident with the default risk) but how about these 25 to 30 year bonds? There is massive inflation risk, not to mention the fact that stocks in decent companies can easily outperform such bonds.

I notice that Buffett invests in shorter term distressed bonds. Amazon and Level 3 Communications were quite short if I recall correctly. In contrast, Martin Whitman is more than happy to invest in 20+ yr bonds.

What would be appropriate yield for a 30yr bond? Assuming you are ok with the default risk, what yield would make you invest in a bond rather than equity?

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