What about High yield bonds?
Another reader question prompted us to look out into the future (always a daunting task). One should always remember that what you are about to read is pure fiction at this point in time as opposed to editorial or news. Our crystal ball has been getting bad reception ever since cable became the preferred mode of mass communication in this country, so don’t put too awfully much credence into what you are about to read.
The subject it high yield bonds and by implication converts too. The converts today are mostly just low coupon high yield bonds as most of the conversion features aren’t worth much any more. The so-called optionality in these bonds has long ago been left for dead. But, if we are very lucky, that option value may come back and add a little whipped cream and nuts to the chocolate sundae we’re enjoying with our converts investment.
The question is what do we think is going to happen in high yield? Where is it going and how are we going to get there? Is it going to be as pleasant a journey as the last six months have been? How long could this go on? When it is going to end?
Some of these questions are asking for more specific information than we can frankly provide, but we will try to make some predictions about when and where we are headed with that investment.
The point of the high yield and by implication the convertible, investments was to take advantage of a huge mis-valuation in these bonds brought on by the sheer panic in the bond market last year in October. It was only early 2007 when high yield bonds were near historically narrow spreads (tights) to Treasury bonds at only 250 basis points (2.5%). From mid 2008, those spreads widened out to close to the old record wide spreads as the foundation of credit market began to crack and crumble. Then in October, the spread on high yield gapped-out by about 1000 basis points (10%), to new record levels. That got us very interested in high yield as a potential investment. However, by late November, the spreads had widened even more to the current record of roughly 2100 basis points (21%) over Treasuries. When you consider that Treasuries were 3% at the time, 2100 basis points is a bit of an over-reaction.
So, when we started into high yield, the idea was that with a spread like that, things would have to be a lot worse than we expected to make the spread widen even more. Our discussions with high yield managers, strategists, and other bond professionals reinforced our outlook that a spread that big could withstand any eventuality. Here’s how that math worked – you buy a bond at about half-price, the coupon is about 7% maybe 8% and even if it defaults, you might get 30% of the face value back in bankruptcy. So, you get a 24% yield to maturity to wait and see what happens, in case of default you get 60% of your money back (30% recovery when you paid 50%), even if it takes a while to get the cash. If things get even remotely better, the whole environment will reward you by taking the bond back up to 70% or 80% of par value. The high yield guys were arguing that you could have defaults at 20% a year virtually forever and still make money on the bonds because the price was so low and the coupon so high.
So, we entered high yield in October and increased out weight in February. So, what happens next?
Our outlook is that we will enter a period where defaults actually get far worse than we have experienced so far. That will be a big test for the high yield marketplace. The thought is that even this worse level of actual defaults won’t be as bad as is already priced into the bonds’ current values and so the bonds will retain their value and maybe even prosper though we expect a lot of jostling around during that phase.
The other aspect besides defaults that we worry about is the possible rise in interest rates as we move inexorably from recession to recovery to expansion. The thought is that given the very high coupons and improving credit situation, that for a while after recovery turns to expansion, high yield can provide a decent place to stick around, but we might move to floating rate during this phase as we would get any benefit from rising rates in our income stream with the floating income.
High yield and converts actually outperform high grade bonds over entire cycles, but the volatility is a big offset to the better performance. So, when you start with high yield, you have to assume you are going to finish with high yield at some time. When is the problem? The best guess is that we will stick around at least until the spreads tighten fairly dramatically from here. Whether we make it back to ‘normal’ levels around 450 to 500 basis points we don’t know. We should continue to tighten since except for the last six months, current spreads in high yield would be all-time wides. There are plenty of basis points left to go for now.
When will we get out? We are watching several factors: price, spread, yield levels, duration, and defaults. By the time the price gets back close to par for the average bond, we will be a lot less intrigued. If the spread get closer to normal, say 600 over of so, we will no longer have the cushion from yield we now enjoy. If yields overall start going back up, then our interest in any bond really wanes. If the duration of the fund starts getting out there, we could make a change either to another fund or to floating rate. Defaults could just get out of control. If we see a lot more defaults than are currently anticipated by the high yield market, then we should reconsider.
This whole process could take years. It is a good story about how we reacted positively to the craziness that was going on last fall.
The Homebuilders Index, an index of sentiment of homebuilders about the future of their business, rose to 16 from 14 the prior month is the first glimmer of hope from the homebuilders in many, many months. This index is a diffusion index where you net the folks saying better against the folks saying worse. If you have equal numbers of both, you get a reading of 50, so we’re on balance worse than that. But, a few years ago, this index was routinely in the high 70’s and 80’s when we were about as optimistic as we are pessimistic now.
Leading Economic Indicators flashed an all clear in April. That’s overstating the case quite a bit, but hyperbole seems to be in vogue these days. What the leading indicators actually said was that things aren’t getting any worse and might be getting a little better. The rise of 1% follows seven straight months of declines in the index which is designed to predict changes in the GDP six to nine months in advance. (By the way, it does a pretty crappy job of that, but that is a rant for another time.) If we get several more increases in the index in the next few months, then the odds of a rebound in the economy go way up.
Housing starts hit a new cyclical low in April of only 458,000 units. Wow, only 458,000 units for a nation that is adding nearly two million new households a year. That can’t keep up forever, but it could keep up for several more months until we slowly eat through the inventory of homes on the market.
US stocks were virtually unchanged last week. Ups and downs essentially cancelled each other out. The big Monday rally was wiped-out by declines over the balance of the week. Sound familiar? It could be we’re doing the same thing this week.
By contrast, the foreign markets were generally stronger. A 3.5% decline in the dollar against a basket of our biggest trading partners helped the foreign shares advance.
Foreign bonds were also winners due largely to the dollar decline. The dollar was declining as much on stronger conviction that the global recession was coming to an end as anything else. With equity and bond markets around the world gaining, there is a lot less need for a safe haven in ultra-safe, dollar denominated, short-term instruments. Unwinding all that fear and loathing may not be so good for the dollar in the short-run.
US bonds were mixed again with Treasury bonds generally declining and taking some of the very highest grade mortgages and corporates with them. At the same time, high yield bonds and municipal bonds were generally higher.
Real estate securities were mostly higher but acting much differently than the financials which have had real estate on a leash here recently. The gain was despite a mixed return on financial shares last week.
Commodities were higher due to the huge gain in oil prices. West Texas Intermediate, the most commonly traded oil future on the NYMEX, gained over 8% on the week. Surprise, surprise, just as the driving season begins there is an outsized rally in oil and gasoline. If you care to follow this closely, just watch the weekly Department of Energy reports on energy inventories and you’ll see that demand for energy doesn’t really change much during the summer, less than a million barrels worldwide on a weekly basis. But, traders have it in their heads that this is a tradable proposition so they trade it. Like the Japanese traders say “if we all cross against the light together, no harm can come to any of us.”
Hopefully, we all had a great Memorial Day weekend. With gas prices down from last year, more of us were on the highways and so more of us got killed on the highways. That is just the way that tends to work. There are a certain percentage of us who will drink to excess and still try to drive home, or will drive too far and get too tired and well you can guess the rest. If you have teenage or twenty-something children and they managed to escape another three-day weekend unharmed, take an extra second and give them a hug. Next time, they might not be so lucky.
Have a really great week.
Schroeder Financial Services, Inc.