essays pieces of the puzzle
Saturday, September 29th, 2012
be scared

I don’t usually revisit a particular topic very quickly, but yesterday I saw a posting on LearnBonds which alarmed me.  It was titled, “Don’t Be Scared to Purchase Individual Junk Bonds.”

It was just two weeks ago that I did a posting called, “a great time for junk.”  The great time it references is the last few years, which the next few are highly unlikely to repeat, despite the fact that people continue to pile in.  The short posting shows a long-term chart of the high-yield market and offers perspectives on credit, interest rate, and investor risk.

The LearnBonds piece prompted a tweet from me that I was tempted to issue a market call after reading it (something I don’t do).  The advice from the author, “The Financial Lexicon,” is the kind you see at tops, not bottoms.

Basically the message is that it’s OK for investors to buy junk bonds rated BB or even B because average default rates over time are lower than you might think — and that therefore you shouldn’t be scared to invest in individual bonds with those credit ratings.  But you don’t get average default rates, you get prospective ones.  And you don’t get yields to offset them that are average either, you get today’s low ones.  And you get the results from particular bonds, not index returns.  You are an experienced credit analyst, aren’t you?

The chart above starts at another time when people weren’t worried about risk in junk bonds.  The Fidelity Focused High Income Fund (FHIFX) was made up of almost all bonds rated BB.  (Or Ba if you’re using the Moody’s system.)  The BlackRock High Yield Portfolio (BHYAX) was heavily concentrated in B names.  This is how some professionals did during a time of stress; how do you think you’d do?

Of course, I could have extended the time period and you’d see that the funds eventually bounced back and did fine.  But I stopped it here because investor behavior is such that this is when investments get puked out.  I’ve seen professionals do it and I’ve seen individuals do it.  The time to be not scared is when you’ve done your work and everyone else is scared.  That was then, this is now.

Not mentioned in the article is that it’ll cost you quite a bit in transaction costs (seen or unseen) to buy the bonds and if you feel like selling them you might find that there are either no bids or that you get clipped very hard trying to get out.  In addition, many bonds are callable, which means your upside is limited but your downside isn’t.  (Here’s a nice chart from Morgan Stanley that shows the lid that the calls put on bond prices.)

If you want to “learn bonds,” here’s an easy way to get an expensive lesson:  Buy a bunch of individual junk bonds and keep track of the number of different ways you get surprised.  And send me your results in five years.  (Chart:  Bloomberg terminal.)