As users of the Moneybags© mobile financial application(1) know, the Moneybags sample “opportunistic” portfolio(2) has long had an exposure to junk bonds.(3) That exposure has produced prodigious returns, but the question arises: is it time to junk junk?
In my experience there are three kinds of investors in junk:
True Believers. These folks maintain a permanent allocation to junk bonds year in and year out. They might increase or decrease the allocation depending on how they like the market, but they would no more be absent from the sector than most of us would be absent from, say, US large caps. Their view, perhaps over-simplified, is that over a full market cycle junk tends to be under-valued. They might even be right.
“Fair Weather” Investors. These folks invest in junk when spreads are wide and defaults are low, and they tend to exit the sector when spreads narrow and/or defaults rise. Moneybags is an example of a fair weather investor in junk.
The Clueless. Clueless investors buy junk because they’ve noticed – or, more likely, their brokers have pointed out – that junk yields look terrific. During periods of Financial Repression, when central bankers are artificially keeping yields low, clueless investors pile into junk feet first without any understanding of or appreciation for the risks they are incurring.
The reasons it might be time to junk junk are compelling:
- Junk yields are at an all-time low, suggesting that junk buyers are being undercompensated for bonds that might default.
- Retail investors have loaded up on junk at record-breaking rates. (What retail investors do is generally a terrific contrary signal.)
- Below-investment-grade issuers are not only floating junk bonds at record rates, they are increasingly using the proceeds for alarming purposes (paying off private equity funds, for example, or making acquisitions).
- We are dangerously close to a return to the days of “covenant lite” loan agreements. Interest-optional payment features are already becoming common among weaker borrowers, for example.(4)
- Investors are so hungry for yield that they are chowing down on southern European corporate debt and – are you sitting down? – junk issued by Chinese property developers.
So naturally you are thinking that Moneybags will be junking junk and moving to something safer. But not so fast. There are reasons to proceed cautiously in junking our junk:
- While it’s true that absolute junk yields are very low, spreads are at normal levels.(5) This suggests that junk is fairly valued, not over-valued.
- Defaults are practically nonexistent, suggesting that we are being well-compensated for the risk.
- The Fed has solemnly promised to keep interest rates low for at least another year, probably longer. In other words, investing in junk is simply taking advantage of the “Bernanke put.”(6)
- Not investing in junk, but investing in other bonds, means losing money every day relative to inflation.
- There just aren’t that many compelling options for the capital we’d be moving out of junk.
So what’s a poor Moneybags app investor to do? One possibility – the one I’m adopting in the Moneybags “opportunistic” portfolio – is to balance out the junk exposure with an exposure to leveraged loans.
Leveraged loans are bank loans made to below-investment-grade borrowers. But unlike junk bonds, the interest rate on the loans floats (subject to certain limits). Thus, if interest rates should rise – a disaster scenario for junk – leveraged loans would (theoretically) be ok. 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.
Another option, available only to accredited investors, would be to hire a hedge fund manager who is skilled at playing the bank debt market. These managers tend to thrive whenever there is a dislocation in junkland.
Sometime, perhaps soon, it will be time to junk junk. I know many thoughtful investors who are already moving out. But for now I’m sticking with it (and holding my breath).
(1) The app is available as a free download on the Apple App Store or, for those of you not yet colonized by Battleship Apple, at www.MoneybagsApp.com.
(2) The Moneybags “sample” portfolio is emphatically not a portfolio that is recommended for any particular investor. It’s simply an example of how best-in-class portfolios get built.
(3) Aka high yield bonds, as they are usually called by people who are trying to sell you some.
(4) Covenant-lite loans totaled $8.5 billion in 2010, $58 billion 2012.
(5) I.e., the difference (the “spread”) between the yield on junk and the yield on a better-rated security of comparable duration (a Treasury or investment-grade corporate bond).
(6) In the 1990s equity investors were lulled into insensibility by the “Greenspan put,” that is, the belief that the Fed would always bail out stock buyers and therefore everyone should “buy on the dips.” In 2000, the post-Tech Bubble “dip” dipped almost all the way to zero.
Next up: Spending Some Time on Spending (but not until March 8, too much travel)
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.