Be careful with diversified bets on junk bonds
In one my posts from yesterday where I was expressing dissapointment at the inability to purchase select junk bonds at reasonable yields, the user BigBeluga suggests junk bond ETFs and shares of companies that deal in venture capital financing or distressed lenders (he suggests a company that I'm unfamiliar with: HTGC.) I thought this was an important issue for anyone looking at high yield bonds so thought I would write a post with my views. I don't like his first idea (junk bond ETFs) but his latter idea (shares of companies that deal in them) seems more attractive.
Not A Fan of Junk Bond ETFs
BigBeluga mentions the two popular junk bond ETFs: JNK and HYG. Both of them have posted horrible returns this year. For example, the iShares iBoxx $ liquid high yield index has an year-to-date return of -30.65% (not sure if this includes interest/dividends) versus -9.12% for the iBoxx $ liquid investment grade index; +11.7% for Lehman 3-7 yr Treasury index (HYG has average maturity of around 7 years); and -37.66% for S&P 500. None of this should be surprising given that junk bonds behave like equity. In fact the big sell off is what makes them attractive. So why do I not like the ETFs?
The common view when it comes to high yield bonds is to always invest in a diversified portfolio. But I'm trying to be a stockpicker and pick select specific ones. It's sort of like saying that I'm not in the game of picking mutual funds and, instead, only pick individual stocks. This is simply a personal reason.
Junk bond yields are high--higher than during the Great Depression if you look at spreads against Treasuries (but junk bonds were not common until the 80's; also Treasury yields are extremely low right now)--but the situation now is not the same. In particular, I have zero faith in all those covenant-lite LBO bonds that were issued in the last 5 years. I have no doubt that these bonds consist of a sizeable portion of these passive indexes. My impression is that the covenants had been relaxed so much, including some bonds which allow the debtor to pay you with more bonds (rather than cash,) that we may be looking at situation similar to the subprime housing situation (where a subprime mortgage from 2006 is not the same as it was in 2000.)
Furthermore, a bond ETF, just like when owning a mutual fund versus some stocks, could consist of bonds that one may be bearish on. Everyone has their opinion on what is and isn't worth owning. As for me, I would not want to own bonds associated with the auto industry, homebuilders, retailers, and so forth. I don't mind owning bonds of specific companies within those industries--say Sears bonds--but I don't want to own the industry.
Lastly, my whole purpose of looking at junk bonds is to get high returns in a company I like. You will only get this on specific bonds of specific companies. For example, I wanted the Sears bonds because they had yields of around 20% to 30% with some bonds even having yield to maturity of 40%. You can't get these numbers by buying the ETF. You avoid the risk of picking the bad apple but you give up all the upside. Given that stocks are quite attractive, a lower yield, say 15%, on the ETF is just not worth it. For example, you can find blue-chip companies with likely long-term earnings yields of around 8% to 10% (P/E close to 10). Companies ranging from Microsoft to 3M to Diageo to ExxonMobil have (likely long-term) P/Es around 12. So if I were to consider a high yield bond, it better have a sizeable yield to make it more attractive than stocks (recall that stocks have lower tax rate (at least in Canada) and can compound at the ROE rate.)
How About Alternative Strategies?
I don't know much about HTGC but that's something one may want to look at. Cursory look leads me to believe that it is a company that provides financing for risky firms (start-up financing, seed capital, bridge loans, etc.) Depending on how these companies source their capital, and how well management runs operations, it may be worth looking into these. I personally don't have an interest in them because it looks way too risky for me and it is not an area I'm familiar with.
Other alternatives to junk bonds is to look at closed-end funds that invest in junk bonds, leveraged loans, bank loans, and the like. I remember mentioning low quality bond ETFs and CEFs more than an year ago. At that time, I said we should watch low quality bond funds and consider buying them after they have been hammered down. Well, some of what I was speculating on, such as a slowing economy and a collapse in non-mortgage bonds, has unfolded. My view right now is slightly different from back then. An year ago I said we should consider buying low quality bonds after they have dropped. Right now, I believe you do not need to go for the low quality bonds anymore. News articles seem to indicate that almost everything has been sold off so you may be able to find good deals on high quality assets. I'm not sure how easy it is for small investors but senior bonds, corporate loans, trade credits, and the like, are probably better. (as a side note, if you are an expert and have access to the whole investment universe, then you may, as Jim Grant has suggested, consider buying select mortgage bonds (i.e. those not in the 'sand states', higher FICO scores, etc.)
So to sum up, I think an idea is to look for CEFs (closed-end funds) that invest in senior loans or something like that. Ideally, one should buy the CEFs when they are trading below what you think is the correct net asset value. The primary risks with such a strategy are the following. CEFs may use leverage so you need to be certain that they won't face funding issues. It's never clear if the management of these CEFs know what they are doing. In contrast, ETFs generally track a passive index so there is little room for management incompetence. Finally, even if you buy a CEF at a discount to NAV, one can never be sure if that discount will close in a reasonable time frame.
Not A Fan of Junk Bond ETFs
BigBeluga mentions the two popular junk bond ETFs: JNK and HYG. Both of them have posted horrible returns this year. For example, the iShares iBoxx $ liquid high yield index has an year-to-date return of -30.65% (not sure if this includes interest/dividends) versus -9.12% for the iBoxx $ liquid investment grade index; +11.7% for Lehman 3-7 yr Treasury index (HYG has average maturity of around 7 years); and -37.66% for S&P 500. None of this should be surprising given that junk bonds behave like equity. In fact the big sell off is what makes them attractive. So why do I not like the ETFs?
The common view when it comes to high yield bonds is to always invest in a diversified portfolio. But I'm trying to be a stockpicker and pick select specific ones. It's sort of like saying that I'm not in the game of picking mutual funds and, instead, only pick individual stocks. This is simply a personal reason.
Junk bond yields are high--higher than during the Great Depression if you look at spreads against Treasuries (but junk bonds were not common until the 80's; also Treasury yields are extremely low right now)--but the situation now is not the same. In particular, I have zero faith in all those covenant-lite LBO bonds that were issued in the last 5 years. I have no doubt that these bonds consist of a sizeable portion of these passive indexes. My impression is that the covenants had been relaxed so much, including some bonds which allow the debtor to pay you with more bonds (rather than cash,) that we may be looking at situation similar to the subprime housing situation (where a subprime mortgage from 2006 is not the same as it was in 2000.)
Furthermore, a bond ETF, just like when owning a mutual fund versus some stocks, could consist of bonds that one may be bearish on. Everyone has their opinion on what is and isn't worth owning. As for me, I would not want to own bonds associated with the auto industry, homebuilders, retailers, and so forth. I don't mind owning bonds of specific companies within those industries--say Sears bonds--but I don't want to own the industry.
Lastly, my whole purpose of looking at junk bonds is to get high returns in a company I like. You will only get this on specific bonds of specific companies. For example, I wanted the Sears bonds because they had yields of around 20% to 30% with some bonds even having yield to maturity of 40%. You can't get these numbers by buying the ETF. You avoid the risk of picking the bad apple but you give up all the upside. Given that stocks are quite attractive, a lower yield, say 15%, on the ETF is just not worth it. For example, you can find blue-chip companies with likely long-term earnings yields of around 8% to 10% (P/E close to 10). Companies ranging from Microsoft to 3M to Diageo to ExxonMobil have (likely long-term) P/Es around 12. So if I were to consider a high yield bond, it better have a sizeable yield to make it more attractive than stocks (recall that stocks have lower tax rate (at least in Canada) and can compound at the ROE rate.)
How About Alternative Strategies?
I don't know much about HTGC but that's something one may want to look at. Cursory look leads me to believe that it is a company that provides financing for risky firms (start-up financing, seed capital, bridge loans, etc.) Depending on how these companies source their capital, and how well management runs operations, it may be worth looking into these. I personally don't have an interest in them because it looks way too risky for me and it is not an area I'm familiar with.
Other alternatives to junk bonds is to look at closed-end funds that invest in junk bonds, leveraged loans, bank loans, and the like. I remember mentioning low quality bond ETFs and CEFs more than an year ago. At that time, I said we should watch low quality bond funds and consider buying them after they have been hammered down. Well, some of what I was speculating on, such as a slowing economy and a collapse in non-mortgage bonds, has unfolded. My view right now is slightly different from back then. An year ago I said we should consider buying low quality bonds after they have dropped. Right now, I believe you do not need to go for the low quality bonds anymore. News articles seem to indicate that almost everything has been sold off so you may be able to find good deals on high quality assets. I'm not sure how easy it is for small investors but senior bonds, corporate loans, trade credits, and the like, are probably better. (as a side note, if you are an expert and have access to the whole investment universe, then you may, as Jim Grant has suggested, consider buying select mortgage bonds (i.e. those not in the 'sand states', higher FICO scores, etc.)
So to sum up, I think an idea is to look for CEFs (closed-end funds) that invest in senior loans or something like that. Ideally, one should buy the CEFs when they are trading below what you think is the correct net asset value. The primary risks with such a strategy are the following. CEFs may use leverage so you need to be certain that they won't face funding issues. It's never clear if the management of these CEFs know what they are doing. In contrast, ETFs generally track a passive index so there is little room for management incompetence. Finally, even if you buy a CEF at a discount to NAV, one can never be sure if that discount will close in a reasonable time frame.
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