Navigating The Depths of Junk Bonds

January 22nd, 2014 by

junk-bond-yieldsLast week, we examined the landscape for near-investment-grade bonds, specifically those rated BB or BB+ by S&P. Although technically considered junk, we discussed how BB rated companies may have solid business models with near-term issues or an over leveraged balance sheet. Today I’d like to extend the discussion of yields and strategy within the high-yield space, this time examining full fledged junk debt with credit ratings of ‘B’ and below, as rated by Standard & Poors.

 

To see a list of high yielding CDs go here.

 

Here is a random sampling of issuers and yields to be found:

From these listings, we see two very speculative bonds yielding 13%, JCPenney, which by all accounts is teetering on the verge of bankruptcy, and a Venezuelan sovereign bond priced at a very significant discount to par. The other three issues, Clear Channel, Columbia and Tenet provide yields which are probably more reflective of current mainstream junk debt.

To provide additional color on the situation, let’s compare these yields to what is available with two widely held ETFs, JNK, the Barclay’s product and HYG, the iShares offering.

JNK: 40 basis point expense ratio

HYG: 50 basis point expense ratio

To simplify, it appears with JNK that we are getting a low “6ish” yield for buying debt with roughly 6.5 years of maturity and a “B+ish” credit profile. With HYG, we may be getting a slightly lower real yield due to shorter maturity and although I did not illustrate it, a slightly more creditworthy risk profile in the BB realm.

We can also look at yields from unlevered closed-end funds trading at a discount to net asset value. The following is the result of a search conducted on CEFconnect.com:

Here we have yields ranging from the mid “5s” all the way to the low “8s.” Distribution variations are typically resolved by analyzing differences in credit profile and length to maturity.

Strategy

I’m generally hesitant in recommending bond funds because of the innate uncertainty of principal in a rising interest rate environment,. However, when one starts looking at the depths of junk debt, it may be prudent to consider pooled products. Still, for the more credit savvy and risk tolerant bond investor, a diversified portfolio of many junk issues may be the right solution. But for those disinclined to place a handful of bets on whether Venezuela, JCPenney, or other high-yield companies will be able to avoid default during a liquidity crisis or declining economic climate, a professionally managed, diversified fund may be answer.

Frankly, I think the best high-yield value is in the closed-end space, where one can find yields similar to, or greater than, current supply on the secondary market. And though one may be taking a bit more credit and maturity risk than JNK or HYG, I think on a risk-adjusted basis, I’d take the 150-225 basis point advantage of the CEFs compared to what I’m getting with the ETFs.

Conclusion

With high-yield default rates continuing at a rather nominal pace, investors have been quietly, and without issue, collecting interest payments from not-so-credit-worthy entities. However, one must not become complacent with junk debt, – the potential risks are very real – as we found out five years ago when default rates spiked. Thus, one must understand the pitfalls when making a loan to a company without top-notch financials and/or a proven business model. Though JCPenney-type  situations have tended to be few and far between over the near-term,  I would argue that one must approach deep junk debt with a worst case scenario mentality and determine independently whether the available yield rewards are   portfolio appropriate or not.

About the author:

aloisiAdam Aloisi has over two decades of experience investing in equities, bonds, and real estate. He has worked as an analyst/journalist with SageOnline Inc., Multex.com, and Reuters and has been a contributor to SeekingAlpha for better than two years. He resides in Pennsylvania with his wife and two children. In his free time you may find him discussing politics, playing golf, browsing antique shops, or traveling.

 

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