Users of the Moneybags© app(1) will recall that slightly more than a year ago (post of 2/22/13) I examined the case for junk bonds,(2) to which Moneybags had a 10% opportunistic exposure.
At that time the environment looked unpropitious for junk. Their yields were at an all-time low, retail investors were loading up on them, issuers were using the proceeds for alarming purposes, the bond covenants were lite-to-non-existent, and the yield on junk had recently dropped below the yield on the S&P 500 Stock Index (for, as far as I can recall, the first time in history).
Naturally, you are supposing that I had blown junk out of Moneybags’ portfolio muy rápido. But, no! Why not?
Well, because we live interesting times. Everything I just said about junk was true, but there was more to be said: although yields were very low, spreads(3) were about normal; defaults were almost nonexistent; the Fed was promising to keep rates low practically forever (the “Bernanke put”); and moving the junk allocation to investment grade bonds meant losing money every day to inflation.
So, basically, I chickened out. I took half the junk allocation and moved it to leveraged loans, which are bank loans made to below-investment-grade borrowers. But unlike junk bonds, the interest rate on the loans floats (subject to certain limits).(4) Thus, if interest rates should rise – normally a disaster a scenario for junk – leveraged loans should, theoretically, hold up better. In addition, while junk bonds are mainly unsecured obligations of the issuer, most leveraged loans are well-collateralized. Finally, because of their ultra-short duration, leveraged loans aren’t as highly correlated to equities as is junk.
Later, I chickened out some more and dropped the junk allocation altogether, increasing Moneybags’ allocation to leveraged loans to 10%. How’d that work out? The answer is – don’t ask.(5)
Batting .000, I now step up to the plate and take a walk: Moneybags has moved the entire 10% allocation to leveraged loans out of the portfolio. My reasoning is that all the bad things about junk and leveraged loans are still true, but some of the good ones aren’t.
For example, the spread between lower-rated securities and investment-grade securities is now down to about 100 basis points. Not only is that a record low, but it simply isn’t enough to compensate investors for the much higher risk of lending to weak companies. In addition, the Fed has begun to taper its bond purchases, making investors less inclined to take risk (even if they don’t know it). Finally, although the US economy continues to improve in fits and starts, consumers seem reluctant to spend, putting smaller, highly leveraged companies in a bind.
Moneybags took the 10% it had placed in bank loans and divided it between hedge funds and intermediate term investment grade fixed income. Hedge funds because the market is transitioning away from the mindless, momentum-driven strategies that worked so well in 2013 to more differentiated strategies that play into the hands of hedge fund managers. High grade bonds because as I look around the world I simply don’t see any screaming opportunities and so am keeping some powder dry.
Since the Moneybags portfolio is designed for smaller investors, this seems to me like the best policy. But note that for accredited investors there are other options. For example, several hedge fund managers play in the junk bond and leveraged loan markets and they are extremely nimble. For larger investors, therefore, there is likely to be more money to be made in these sectors, even net of the risk. The rich continue to get richer.
But for small investors, this game is over for now.
(1) Moneybags© is a mobile financial application invented by your humble scrivener as a way for smaller investors to learn (slowly, over time) what a portfolio should look like and how it should evolve. The app is available as a free download on the Apple App Store or at www.MoneybagsApp.com.
(2) In case someone doesn’t know what a junk bond is, it’s a bond issued by a less-than-investment-grade company. They are sometimes called “high yield” bonds, usually by people who are trying to sell you some.
(3) The “spread” is the difference between the yield on junk and the yield on an investment-grade security of comparable duration (a Treasury or investment-grade corporate bond).
(4) Most leveraged loans are subject to LIBOR floors, which are above the LIBOR spread. Thus, until the spread rises above the floor, the loans can decline in price as rates rise.
(5) Junk was up more than 2.5% during that period, intermediate bonds rose roughly 100 basis points less, and leveraged loans, damn their eyes, rose a measly 1%.
Next up: What to Do When There’s Nothing to Do
Please note that this post is intended to provide interested persons with an insight on the capital markets and is not intended to promote any manager or firm, nor does it intend to advertise their performance. All opinions expressed are those of Gregory Curtis and do not necessarily represent the views of Greycourt & Co., Inc., the wealth management firm with which he is associated. The information in this report is not intended to address the needs of any particular investor