The frothy markets of the 2003 to 2007 time period led to irresponsible lending of all kinds — everything from sub-prime mortgages to debt-laden private equity deals that were infamously dubbed “covenant lite,” meaning they lacked many of the basic protections afforded creditors in more normal economic climates. Lawrence Jones of Morningstar observed in a recent research note: “In 1997, the overall size of the high-yield debt market in the United States was a bit more than $350 billion, but by the beginning of 2007, that marketplace exceeded $1 trillion, in part helped along by the 2005 addition of Ford and General Motors to the below-investment-grade universe and the proliferation of leveraged-buyout deals that effectively involved saddling a firm with a ton of debt.”
The private equity market also contributed to this growth. High-profile private equity deals that closed during the 2003 to 2007 period have already begun to default or look perilously close to defaulting. The leveraged buyout of Linens ‘n Things has already gone bad, with the retailer declaring a Chapter 7 liquidation. Bonds from the late 2006 LBO of former Cendant unit Realogy, a collection of real estate brokerage firms, are trading as though default were likely. And even famed distressed debt investor Steven Feinberg, who runs the multi-billion dollar high-yield hedge fund Cerberus, has seen his purchases of Chrylser and GMAC go badly awry. Feinberg has already attempted to reduce his exposure to Chrysler and GMAC by offering up ownership in exchange for a limitation on his firms' future liabilities should these companies struggle further, an indication that he is not willing to throw good money after bad, despite having invested billions in both. His recent high-profile showdown with PIMCO bond maestro Bill Gross shows how even once-mighty investors have fallen — their public spat over the GMAC refinancing terms was an embarrassingly public argument for the normally ultra-secretive manager. But Feinberg's highly levered deals were a common mistake during the boom years.
And this irresponsibility came home to roost in 2008. Few sectors or asset classes were as badly damaged during the Bear market of 2008 as high-yield bonds, which lost 30 percent from September 15, the day Lehman Brothers filed the biggest bankruptcy in the United States, as measured by the JPMorgan High Yield Bond Index. On December 16, the spread between junk bonds and Treasuries with comparable maturities reached a record 19 percentage points, suggesting bond investors had reached a level of fear never before seen in modern markets. The tightening credit markets began to worry investors in the high-yield sector, and many had been forced sellers of corporate bonds even as their prices declined. Closed-end funds that used auction-rate securities for leverage, hedge funds who borrowed money to increase assets and deploy leverage, as well as investment-bank trading desks, mutual fund managers and retail investors all contributed to the panic, selling whatever securities — whether high-yield or not — without regard to fair value or economic rationality. Such is the nature of credit panics: The baby often gets thrown out with the bathwater.
Time To Buy?
Since the December low, the credit markets have begun to improve, and a rally into year end lifted prices by more than 8 percent off their lows. Funds that buy mostly junk bonds attracted a rush of investor cash at the end of 2008 from investors drawn by yields that beat U.S. Treasuries by record amounts. High-yield funds, which suffered $8.8 billion in net withdrawals during 2008, attracted $1.7 billion during the last five weeks of the year, data from fund-tracking firm EPFR Global show. And there are some smart institutional investors who agree. If you compare the S&P 500 trailing 12-month operating earnings yield to the real U.S. corporate high-yield market, “Corporate high-yield is the cheapest it has been relative to equities in 20 years,” says strategist Barry Knapp of Barclays.
And many money managers agree. “There are some really extraordinary opportunities in the credit world,” said David Swensen, the Yale University investment chief, to Bloomberg TV. “Everything, from bank loans to investment-grade bonds to less-than-investment grade bonds, is priced at really extraordinarily cheap levels.”
Recent results from credit surveys done by Merrill Lynch analyst Mary Rooney show a large sentiment shift to the positive, with 74 percent of respondents now saying that spreads seem to indicate undervaluation and an excessive fondness for investment-grade bonds.
It may take years for the high-yield bond market to recover after the damage it incurred during 2008, but small improvements have already taken place, as recent high-yield offerings suggest the buyers' strike has ended. And spreads have tightened: CSFB found on January 6 that U.S. high-yield spreads have dropped to 16.5 percent from 20 percent and the CDX high-yield index fell to around 1,100 (the peak was close to 1,500).
So is it too late to play in this market, given the recent rally? Probably not — spreads remain much higher than long-term averages. And why is it a good time to buy high-yield corporate as we enter a recession? Because the markets usually price in recessions ahead of time. Citicorp found that out during prior recessionary periods?of 1991 to 1993 and 2000 to 2003. High-yield bonds returned an average gain of 15.5 percent annually in the two recessionary periods compared with 5 percent for the S&P 500 over the same period. Why were both markets positive during a recession? Because the market looked ahead and realized the recession wouldn't last forever. Astonishingly, given the prominence of the recent mortgage debacle, corporate bonds appear by some measures to be cheap relative to mortgage bonds.
Tom Treanor of Morningstar says that recently, “Valuations have changed to the extent that the high-yield closed-end fund sector is now trading at a wider discount than those funds with a primary focus of investing in mortgage securities. On a five-year Z-stat basis, the current spread is 1.6 standard deviations away from the mean, indicating that high-yield, closed-end funds are ‘cheap’ relative to mortgage closed-end funds on a historical basis. Almost 90 percent of observations will lie within 1.6 standard deviations from the mean, so the current discount differential is an unusual case.”
Ways To Play
How can investors participate in this sector? For Frank Evangelist, of No*Load Fund X newsletter, it may be too soon to buy despite the opportunities. “We are mainly in Treasury bond funds, but have some investment-grade exposure, indicating that some bond funds are starting to add value based on our ranking system to warrant taking the added risk versus Treasuries. We also recognize that yields/credit spreads for investment grade bonds, like high-yield bonds, are tempting — and unlike high-yield bonds, many of these issues are reasonable credit risks and investors are buying them causing them to rise in our rankings.”
Still, Evangelist recommends investors interested in the sector consider Janus High-Yield (JAHYX), or a high-yield ETF, such as SPDR Barclays Capital High Yield (JNK) or iShares iBoxx $ High Yield Corporate Bond (HYG). “If I really wanted to dip my toe in high-yield bonds now, I believe the best fund is Loomis Sayles Bond (LSBDX),” says Evangelist. “Loomis Sayles is a flexible bond fund managed by Dan Fuss that has an excellent long-term record and holds a lot of high-yield bonds — and has paid the price lately — but has the flexibility to change if conditions continue to deteriorate and an excellent credit team.”
Evangelist also notes that high-yields funds often have good multiyear performance runs. “We have also found that riskier bond funds like high-yield bonds actually trend well. In other words, we tend to own them for several months to several years when they are a buy versus less risky funds (based on trailing one, three, six and 12-months) and we are consistently happy we sold after they fall in our rankings. For example, we held high-yield bond funds at or near our maximum weight of 30 percent from the inception of our flexible income fund July 1, 2002, until about 2 years ago.”
There are other ways to play the sector as well. High-yield funds with good performance relative to the category, moderate risk, reasonable fees and a manageable level of assets include the ING PIMCO High Yield (PHYX), the Payden High Income (PYHRX) and the RidgeWorth High Yield (SAHIX) funds. The Principal High Yield A (CPHYX) is also worth noting, and has a front load of 4.5 percent.
To be sure, owning high-yield bonds is most certainly not a “can't lose” situation. Further deflation could hurt corporations' ability to repay, as could a more severe recession. But investing in corporate today seems like a much better bet than mortgage credit, and could potentially offer higher returns than equity markets with less risk. Morningstar's Lawrence Jones, for one, is not sanguine. “Heading into 2009, there are various estimates of default rates, but few managers I've spoken to believe it will be any less than 10 percent to 12 percent, and some market observers believe it could be considerably higher, perhaps even reaching 15 percent to 20 percent, if the recession is particularly deep,” Jones says. “Moreover, recovery rates on defaulted bonds may not be as high as past averages, some speculate, in part due to the greater issuance of more senior?bank debt in many firm's capital structures.”
But future defaults remain an unknown quantity, and high default rates will hurt many parts of the market. If the defaults remain reasonable, then current pricing in the high-yield market, despite the recent rally, will prove to be a very attractive entry point.
BETTING ON A TURNAROUND
Closed-end bond funds often use leverage, making these funds riskier than non-leveraged funds. But with leverage comes the potential for higher returns. This list consists of closed-end funds that are trading at a discount to their 5-year average NAV. We removed all funds that issued auction rate preferred shares, that had less than a 5-year trading history and that carry an expense ratio greater than 1.25 percent.
|Fund Name||Ticker||Total Lev Ratio (%)||Discount at Last Close||5Y Avg Discount||Current Discount as % 5Y avg||Price TR 1 Year.||NAV TR 1 Year.|
|BlackRock Debt Strategies Fund||DSU||42.82||-6.58||-0.57||1154%||-50.81||-49.09|
|BlackRock Senior High Inc Port||ARK||38.08||-6.84||-2.01||340%||-43.44||-40.73|
|Credit Suisse Income||CIK||0||-14.67||-5.05||290%||-26.86||-23.58|
|BlackRock High Income Shares||HIS||21.87||-11.43||-5.06||226%||-28.34||-31.45|
|Dreyfus High Yield Strategies||DHF||31.17||-16.72||-8.66||193%||-20.53||-19.5|
|High Yield Plus Fund||HYP||28.17||-10.34||-5.63||184%||-10.41||-14.19|
|MFS Intermediate High Income||CIF||42.52||-13.11||-8.14||161%||-38.84||-34.92|
|High Yield Income Fund||HYI||35.89||-10.8||-7.04||153%||-13.67||-18.15|
|BlackRock Corp High Yield V||HYV||28.1||-12.36||-8.08||153%||-35.19||-35.34|
|MS High Yield||MSY||15.59||-17.81||-11.97||149%||-21.78||-18.78|
|BlackRock Corp High Yield III||CYE||31.45||-11.08||-7.7||144%||-34.09||-35.94|
|BlackRock Corp High Yield||COY||30.37||-8.41||-6.22||135%||-30.93||-35.09|
|BlackRock Strategic Bond||BHD||1.52||-5.94||-4.96||120%||-7.78||-16.69|
|BlackRock Corp High Yield VI||HYT||28.43||-10.78||-10.01||108%||-34.78||-35.24|
|Managed High Yield Plus||HYF||34.7||-3.62||2.29||-158%||-55.6||-54.39|
|DWS High Income Trust||KHI||32.21||-13.39||8.2||-163%||-31.2||-24.49|