Looking at the recent history of junk bond spreads, advisors might easily conclude that they are in a bubble—prone to burst—earning investors returns of 20% or higher across a diversified asset class.
But all that glitters—or in this case, emits the malodorous stench of a junk yard—may not turn to gold.
Unquestionably, high-yield spreads against 10-year Treasury notes are at their highest level ever, as the data below from Merrill Lynch shows. Ten-year Treasuries yield approximately 3% and, when that is added to the high-yield spread of 1,600 basis points, investors might conclude that a diversified portfolio of these bonds would yield nearly 20%.
Across the range of high-yield mutual fund and ETF offerings, however, no fund offers yields to maturity close to the 20% level. Most yield 10% to 14%, because they are constructed of higher credit and shorter maturity bonds and, for the actively managed funds, investors pay expense ratios of approximately 1%. On top of this, actively managed funds often have high turnover—50% or more.
A word of caution is in order here. When choosing among bond funds, advisors need to obtain the fund’s average yield to maturity, rather than rely on two more common, but misleading, metrics. Yield to maturity is markedly different from both the 30-day SEC yield (a nearly useless metric that resembles the “current” yield) and the trailing 12-month yield published by Morningstar—which measures prior performance and not the current holdings in the portfolio.
Still, you might think a 10% to 14% yield is not that bad, considering the paltry yields available in the Treasury markets. Such logic requires you to assume that, if a fund is sufficiently diversified, the default risk can be minimized, and a good active manager can pick those bonds least likely to default.
Default risk is a big deal when it comes to high-yield bonds. Junk bond advocates claim the market is already pricing in Armageddon-like scenarios. But a lot of junk bonds really are junk—the remains of highly leveraged transactions orchestrated by the private equity industry, leaving thinly capitalized issuers struggling to survive.
Survival requires refinancing that debt, and approximately $680 billion of corporate debt will mature by the end of 2009. As of early April, Moody’s was forecasting a default rate of over 15% for U.S. companies, up sharply from 4.5% at the end of 2008. With credit markets frozen, issuers are unlikely to rollover their debt, and will be forced, instead, to plead their cases in the bankruptcy courts.
In the event of default, recovery rates are likely to be low. Asset recovery is typically based on real estate values, and it is likely the value of bankrupt companies’ commercial real estate may be insufficient to achieve historical recovery rates of 60% to 70% on defaulted debt. Recovery rates have already dropped to 20% to 40%.
The government’s Public-Private Investment Program (PPIP) may be the final wrecking ball for the junk bond market’s coffin. PPIP investors are being enticed with 20% returns, along with low-interest, non-recourse financing. Clearly, a PPIP investment offers a better risk-return profile than the high-yield market, and this will push high-yield spreads to new highs.
Don’t think for a second that credit research by active managers can sidestep defaults. Consider an actual (but nameless) active high-yield fund with $400 million in assets. This fund has 150 holdings and a 100% turnover, indicating that it is lending nearly $3 million to a new borrower each year. There are 10 credit analysts supporting the fund, and let’s assume that these analysts spend 25% of their time on this fund (with the remainder spent on administrative duties and other funds managed by the fund company). This means each analyst spends about four days per year on each issuer. Would you lend $3 million to a highly risky borrower based on four days of initial and follow-up research?
A bet on an actively managed high-yield fund—just like a bet on a high-yield ETF—is a bet on default rates and recovery rates. So be sure you are confident that the economy will recover, that interest rates will recede, and high-yield issuers will survive in industries where they face better capitalized competitors.
If not, that odor you smell may be coming from your junk bond fund.
Robert Huebscher is founder and CEO of Advisor Perspectives (www.advisorperspectives.com), a Web site and newsletter serving the financial advisory industry.