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I think it’s a “guy” thing. But it is somewhat amazing how much “junk” I find – and cannot quite bring myself to part with - anytime I am compelled to clean out the garage, the attic or the basement. So I guess it should not come as any surprise that I find myself enamored from time to time with “junk” bonds. Excuse me, I meant to say “high yield corporate debt." This past weekend there was an article in Barron’s Financial Weekly extolling the newfound virtues of junk and convertible bonds. So as with most things we read in widely read publications such as Barron’s, the question is, “Are they onto something or not?” Being a “junkaholic” I for one am intrigued. Before jumping onto the bandwagon, however, let’s take a slightly closer look at what we talking about.

What Is a Junk Bond?

The term “junk bond” is the slang definition given to a bond offered by a company of less than outstanding credit worthiness. The junk bond market came into being in the 1980s when Michael Milken at Shearson Lehman created a way for companies to raise capital by offering a higher rate of interest on the bonds that they issued. The upside to the company is that it can gain access to capital that it otherwise could not. The upside to the investor is that he or she can earn a far higher rate of interest than they might by simply investing in a treasury bond of the same time to maturity. The risk of course, is that the company will not be able to pay off and will default on the bond.

In essence, the theory regarding investing in junk bonds is that while some bonds will default a given company is unable to pay, the majority of bonds will be paid back and the additional interest earned will more than compensate an investor for the handful of bonds that do default. One key when dealing with junk bonds is to diversify. For most individuals the best way to invest in junk bonds is either via a mutual fund or via a closed-end fund. This allows them to hold a diversified portfolio of junk bonds. Given the fact that each individual bond is a unique risk, this is one case where diversification definitely makes a lot of sense.     

What Makes Junk Bonds Move?

The performance of junk bonds over any given period of time is related to a handful of primary factors, including:

1. The state of the economy. If the economy is great, fewer companies will likely default on their bonds, thus junk bonds tend to perform well. If the economy is poor or declining, more companies will likely end up defaulting on their junk bonds, thus junk bonds tend to perform poorly.
2. The performance of junk bonds is much more closely correlated to the performance of the stock market than the performance of treasury bonds. This is primarily due to the fact that the performance of junk bonds and stocks are more closely tied to business and economic trends than purely to interest rate fluctuations.

Why are Junk Bonds Unique?

Fidelity High Yield Bond (SPHIX) has a correlation of 0.52 with the S&P 500 but only a 0.13 correlation with long-term treasury bonds. This is another thing that makes junk bonds interesting. They are somewhat influenced by changes in interest rates, but nowhere near to the same degree as treasury or high grade corporate debt. And they are influenced by changes in the state of the economy, but not in lockstep with the stock market. In other words, they''re “different” than both stocks and typical bonds. While they track more closely with stocks than with bonds, a junk bond fund is by no means a “closet” stock market index.

Chart 1 – Fidelity High Income (SPHIX)

When to Consider Junk Bonds

The time to buy junk bonds is when:

1. The yield on junk bonds is substantially and meaningfully greater than the yields for comparable treasuries (i.e., there is no reason to assume the risk associated with junk bonds if you are not going to be adequately compensated for assuming those risks).
2. When junk bonds are going up in price.

Now the second criteria seems a little “subjective” to say the least. Still, one great attribute of the junk bond market is the tendency to trend strongly in one direction or the other. To better appreciate this fact, take a close look at the weekly chart for SPHIX in Chart 1 and note the prolonged trends that typically play out. This can make junk bonds easy to trade on a trend-following basis.

Chart 2 below is for a closed end fund, Blackrock Corporate High Yield Fund (COY). The chart you see is a weekly chart with a simple 5-week and 30-week moving average overlaid. Most of the crossover signals that occurred lead to good moneymaking (or loss avoiding) opportunities.

Chart 2 – Blackrock Corporate High Yield Fund (COY)
(Click here for larger image)

As you can see from a quick perusal of Chart 2, the 5-week average has yet to cross above the 30-week average, so technically that method has not yet given a buy signal. Another surprisingly effective method is to buy a junk fund after it rises 2% off of a low and sell when it declines 2% or more from a high. It sounds too simple but has been a highly effective method for a number of years.

Summary

With the stock market bouncing off of recent lows and the economy still presumably headed in a southerly direction, there would seem to be a great deal of risk in owning junk bonds at the moment. So why should anyone consider junk bonds to be compelling now? For one thing the average junk bond fund is presently yielding in excess of 10%, versus just 2.2% to 4.6% for treasury bonds, depending on maturity. Also, there is reason to think that even if a recession does deepen in the months ahead, much of that has already been factored into the markets. If the stock market can hold above it first quarter lows, and if the economy does not fall into the abyss, then junk bonds could presently be offering the kind of buying opportunity that only comes along once in a while.

So is now the time to jump into junk bonds? Given the fragile state of the economy and the risk of further erosion, there remains downside risk. Still, given the current high yields, now would appear to be a good time for investors to start thinking about the possibilities available in the junk bond market.

As always, time will tell.

To search for previous articles written by Jay Kaeppel, please click here.


Jay Kaeppel
Staff Writer and Trading Strategist
Optionetics.com ~ Your Options Education Site 

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