Tuesday, November 25, 2008 3 comments ++[ CLICK TO COMMENT ]++

My next great strategic idea: junk bonds

Last time I had a great idea, it ended up in a disaster. That idea was none other than Ambac, of course. It's still remarkable that Ambac still lingers on--barely--even with its massive exposure to subprime bonds. Someone that wants to make an extremely speculative bet on Ambac now has the option of betting on the mandatory convertible equity units (ABK-Z). It's thinly traded and extremely risky and it would be close to gambling but I just noticed that they were listed on NYSE.

Anyway, I'm thinking of making junk bonds one of my big strategic holdings for the next few years. One similar tactical move I made about an year ago was to allocate a certain percentage to risk arbitrage, whose verdict is still out (depending on how some of the outstanding deals close.) Do recall that I'm a total newbie when it comes to bonds and the only bonds I have owned in my life are Canada Savings bonds :) and GM junk bonds. I am attracted to junk bonds for the following reasons:

  • Can stabilize the portfolio: There is a possibility that we may enter a long, 10 year, bear market similar to the ones in the 70's or 30's-40's. Owning something that provides fixed income can stabilize the returns on the portfolio. (of course, this is assuming these companies don't go bankrupt.)
  • Massive fear in the credit markets: Everything I read seems to imply the investors are fleeing the credit markets, irrespective of fundamentals, and tripping themselves over for government bonds. It should be noted that the carnage in the bond market has been far worse than the equity market--the bond market is not supposed to be as volatile or decline as much. I feel that there is an opportunity for contrarians to take a position against the consensus.
  • Safer than shares: If the worst comes to pass and we enter a massive deflationary collapse, one might lose their shirt on junk bonds but they will still be ahead of shareholders. Even if companies go bankrupt, there is a possibility of bondholders ending up with equity in a reorganized firm or getting some proceeds of any liquidation.

The downside to bonds include the following risks: higher inflation will kill bonds (but I feel that the high yields of junk bonds compensates for that,) higher taxes (I'm trying to buy them in my tax-sheltered account,) and the inability to re-invest interest at original yields (I don't care about this because I can re-invest in other opportunities, including stocks.)

I think it is prudent to avoid recently issued bonds (say in the last 3 years,) that may contain light covenants. Since I don't understand bonds, it's hard for me to tell what is a cov-lite bond and what isn't, so I'm trying my best to avoid the cov-lite bonds used in the LBOs of recent years.

I am primarily looking at distressed companies, whose stocks I was already following or find attractive. In other words, one strategy is to buy bonds of companies that you don't mind owning. This is similar to my risk arbitrage strategy, where I prefer taking positions in companies that I don't mind owning if the M&A deal collapses. I'm purposely avoiding certain industries since due to various risks (e.g. financial companies because they are too hard to evaluate and some may have zero liquidation value upon bankruptcy; homebuilders because their book value may be overstated; forestry companies because the industry is shrinking; auto companies since the outcome after a collapse of The Big Three is hard to predict; etc.) The industries I like are newspapers and retailers.

As Benjamin Graham suggested, I'm only looking at bonds trading way below par. This is quite easy to do given that practically all high yield bonds, especially distressed industries, have been hit hard.

In order to mitigate any inflation risk, it is perhaps best to consider medium-term bonds (say 5 years.) However, I still haven't finalized my thinking on this issue. I'm still trying to figure out if it's worth buying long-term bonds if the yield is high enough.

The ideal bonds to buy are convertible bonds or mandatory convertible bonds (very risky)--you'll notice that Buffett almost always only buys convertibles--but I haven't found any that have a high enough yield and whose business looks like it will survive.

Currently, junk bonds yield around 20% so I'm targetting bonds with yields around that figure. If you are looking at the short to medium term, this is around 20% earnings yield of stocks, or a P/E of 5. (In the long run, stocks with earnings yield of 20% would earn far more than bonds with yield of 20% due to the ability of companies to reinvest at book value and compound without paying taxes.)

I'm still researching but the companies whose bonds I'm looking at right now are the following: Sears Roebuck Acceptance Corporation, New York Times, and Torstar.

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3 Response to My next great strategic idea: junk bonds

November 26, 2008 at 1:13 PM

I don't like GM bonds. They are very risky because GM has massive liabilities, such as their pensions, healthcare, dealerships, etc. One really needs to do their homework and figure out what liability can be minimized and that's too hard for me to say. For instance, can GM actually get rid of brands and get out of contracts with dealerships without heavy penalty? Who knows?

I feel that there is no need to chase the super-high yields of something like GM when reasonably high yields are available elsewhere.

What may be attractive are bonds of auto companies other than the Big Three. Auto parts makers, suppliers, distributors, and so on. I don't know what their yields are but that is an idea...

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