November 30, 2008

Value Idea: Junk Bonds

There is more deep value in debt instruments than equities. Debt at these yields will give you more than adequate returns with a good margin of safety than equities. In the pecking order of bankruptcies, corporate bonds, even high yield, come
before the equity holders. Some consider equities to be the butt of the investing world, as they rank at the bottom of every body else.

In this post I want to focus on Junk or high yield bonds, a more politically correct term after the Drexel fiasco in the 1980s.

Junk bond values reached a historic peak (measured by the narrowness of the spread between junk yields and Treasury bond yields) in June 2007, when they bottomed out at 268 basis points over Treasuries. In the past six months, spreads have doubled, to 1800 basis points. The default rate for high-yield bonds has also been at historical lows of 3%. Currently Junk bonds sell for 60 cents to the dollar.

However, as the economy settling in to what seems a deep and long rescission defaults will spike and could reach up to 17%. At current levels, the market is pricing in a rise in defaults from
3.4% now to 15%-20% as the economy and corporate profits continue to slacken with no end in sight. The record default rate was 15.4% way back in 1933, again during the -- you guessed it -- Great Depression.

To give you an idea of the scale, the default rate in 1933 was 15.4%; in the early 1990s recession, it reached 12%. These are still far in the distance. Over the year to the end of October, only 2.9% of American junk bonds had defaulted, according to Standard & Poor’s (S&P). It expects the rate will rise to 7.6% by September 2009 (or 9.6% if the economy tumbles).

The case for High Yield:
  • Junk yields are high enough that even if defaults hit Depression-era levels, the bonds should beat Treasuries over the coming years.
  • Inter bank lending rates have moved lower so did mortgage rates. You can argue that these are prelude to reduced lending rate for corporate borrowing. If so then you will see meaningful recovery in prices.
  • The market is pricing an unprecedented default rate of 20%; it may be right. But if it's too pessimistic, the long-term payoff in junk bond mutual funds could be tremendous at these prices and yields.
  • As corporations delver and rebuild balance sheets,the best use of corporate cash now may be to buy back bonds at discounts, effectively discharging debt for pennies on the dollar.
  • Recovery rate: When talking about default rates, one has to mention recovery rates. The standard assumption, historical average, is that the recovery rate will be 40%.
The Case against High Yield Bonds:
  • The deleveraging in debt is occurring at an unprecedented level so when the market prices unprecedented 20% default rate, that may be warranted.
  • Can debt maturity be refinanced? With governments also likely to tap the debt markets heavily, investors may be worried about the prospect of their portfolios being weighed
    down by fixed-income assets.
  • Higher rates lead companies to cut back on borrowing. A drop in borrowing typically means less corporate spending and sales growth, another reason why companies won't earn as much money and stock prices will stay low and the credit metrics of borrowers will deteriorate further.
  • In the past decade hedge fund supplied the high yield market now hedge funds are being squeezed by redemption so who will supply companies with cash in exchange for yield.
  • We are in a negative reinforcing cycle that will take some time to be broken. High borrowing cost will prevent companies from rolling their maturing debt forcing more defaults, as more debt defaults junk bond yields will go higher preventing companies from borrowings and defaulting on maturing debt, and so on. Until borrowing costs come down to levels that will make economic sense to businesses, default will move higher and junk bonds will decline in value.
  • The higher the default rates the lower recoveries will be so the standard 40% recover may not be realized. A recovery rate closer to 25% or lower may be more like it. Case in point in 2002 when defaults reached 13% recovery rates turned to be well below the average, actually it was 25%.
  • Default rates can shoot beyond the trough of the business cycle.
In order to make the case for or against high yield bonds, I am going to do a simple stress test. I have the following assumptions:
  • The average high yield bond trading about 61 cents to the dollar,
  • 15% default rate (Please note that default rates will never jump to 15% from its level of 4%. A more realistic scenario for default rates is to ramp up to the 15% mark and that could take a year or more, but for simplicity, I will assume they will jump immediately to the 15%)
  • 40% recovery rate from defaulted bonds.
  • 5 year investment horizon
Given these parameters you will achieve 14% Internal Rate of Return (IRR). That's pretty good. even if we assume a more of dramatic default rates of 20% and recovery rate of 40% then the IRR would drop to 11.5%. Actually if we perform various scenarios of default and recovery rates we come with the following IRR outcomes:

Default %
Recovery rate%


Those returns are enabled by the low price you pay for high yield bonds. Just remember that the price you pay is the major determining factor of expected returns.

Investment Strategy:
A possible strategy here is to be long junk bonds and short equities. If the argument against holding junk bonds is financial armageddon (default rates will be higher than is priced in), then a strategy of going long junk bonds and at the same time, shorting equities should be a profitable one. In the worst case scenario where equities bounce (nothing is wrong with the economy), you
are protected by a rally in junk bonds as well as spreads come in. But should the economy implode, your short will do well and at least you get your recovery rate in junk bonds. If nothing happens, you get you close to 15% plus while waiting for either scenario.

I do not short so if I am going to execute this strategy I will buy a put on an equity index and go long junk bonds.

You can buy individual issues like GM, ford or utilities like TXU or you can buy ETFs like HYG or JNK. There are many closed end funds that hold High yields bonds that are trading at steep discount to their NAV so you can get more margin of safety by buying them.

Personally I prefer to buy the ishares high yield ETF (HYG). I will avoid leverage with closed funds and I will be more diversified than owning one or two issues of bonds. Moreover, HYG's holdings are invested in issues in the health care and electricity sectors, non economic sensitive sectors; those two sectors represent just under 25%.

The pricing of high yield bonds offer tremendous value with small probability of permanent loss of capital. For investors to lose on investment in HYG, for example, the economy has to implode at unprecedented rate, beyond great depression levels.

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