Are Junk Bonds Expensive? An Investor’s and Trader’s ViewFebruary 13th, 2012 by Marc Prosser
Here we will present two different views on Junk bonds. One which argues that by the correct historical measure, high yield bonds are expensive. The other which makes the case that the extra yield on the bonds, more than compensates for the risk.
Really these two different views, represent two different ways of looking at the world. The first view is from a trader’s perspective. Will the market value of this investment go up or down over a limited period of time? The second view is from an investors perspective. Given comparable investment options available to me, is this a good investment? Depending on which question is asked , you might get a very different answer.
LB Summary: The author argues that measuring wether high yield bonds are cheap or expensive by comparing their spread over treasuries to historical averages, is a bad measure. (Spread in this case just means the difference between the yield on a junk bond to the yield on a a treasury of a similar maturity) Instead, he argues that a comparison to a spread of BB rated bonds is superior. By this measure, many junk bonds look expensive.
LB Summary: This video by Putnam Investments is actually entertaining . .well, at least not terribly academic and boring. Paul Scanlon makes the case that Junk bonds offer good value. He starts of with this basic premise: Junk bonds carry a higher interest rate than treasuries because of the risk of default. The key to figuring out if junk bonds are correctly priced is estimating the default rate. Then, he provides his ballpark estimate of defaults over the next few years. If he is in the ball park, the junk bond holder will make a couple extra percent in yield over treasuries after defaults are included.