Tags: hutchinson | asset | class | cheap

One Buyer's Junk Really Can Be Someone Else's Treasure

Tuesday, 30 Aug 2011 01:59 PM

By Tom Hutchinson

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The storm seems to have finally passed. Now, it's time to assess the damage.

I'm not talking about Hurricane Irene, I'm talking about the summer market swoon.

The markets have been tumultuous this summer to say the least. The debt ceiling debate, the European debt crisis, and a faltering economy (GDP grew at an almost recessionary 0.7 percent in the first half of 2011) combined to drive the S&P 500 down 17 percent in just about a month.

Like a hurricane, the turbulent market has altered the landscape. But, instead of redirecting beaches and streams, the market swoon has changed the dynamic of certain asset classes.
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One altered landscape is the world of high-yield, or junk, bonds.

Panic from market volatility and fears of a possible double-dip recession ignited a flight to quality among investors and they purchased Treasurys and exited higher-risk assets, driving down yields on Treasurys and knocking yield spreads on junk bonds to near recessionary levels.

The yield spread (the difference in comparable maturity yields between below investment-grade rated bonds and Treasurys) is a key metric in pricing high-yield bonds. This metric has soared more than 60 percent since earlier this year, from about 4.5 percent to about 7.5 percent today. The credit spread was at 5.35 percent as recently as last month.

But this rise in yield spread, which prices risk in the high-yield market, seems overdone. The key barometer of risk in the asset class, the credit default rate (a measure of percentage of defaults among issuers), has been going down.

The credit default rate among high yield issuers had a recent peak in 2009 at 11.43 percent. As the economy recovered, the rate fell to 5.5 percent a year ago. As of the end of July, the rate had fallen further to about 2 percent and is forecasted to decline still further during the remainder of the year.

So, while the risk premium in junk bond yields has risen, the actual risk has fallen.

The recent selloff didn't seem to take into account that companies have far stronger balance sheets than they did in 2009. Many corporations have trimmed expenses and refinanced debt at historically low rates and now hold record amounts of cash.

The recent market panic seems to have priced in a much higher chance of recession than is rational at this point. While a recession is still possible, it remains unlikely.

Investors who believe the economy won't double dip have a great opportunity in high-yield bonds.

Here's a couple of easy ways to take advantage.

There exist a myriad of high-yield, closed-end funds and ETFs. Closed end funds can offer a higher yield advantage, and added risk, of leverage while ETFs offer lower expenses. Two of the largest ETFs include The SPDR Barclays High Yield Bond Fund (NYSE: JNK) and The iShares iBoxx $ High Yield Corporate Bond Fund (NYSE: HYG).

JNK is an ETF that tracks the performance of the Barclays Capital High Yield Very Liquid Index, an index of below investment grade corporate bonds with above-average liquidity and HYG tracks the iBoxx $ Liquid High Yield Index.

The ETFs are similar in size and composition. HYG holds about 472 securities while JNK has about 225. JNK has a slightly higher trailing yield of more than 8 percent while HYG currently yields about 7.75 percent. A somewhat lower risk alternative is the PowerShares Fundamental High Yield Corporate Bond Fund. This ETF invests in mostly higher rated bonds while paying a lower yield of about 6.54 percent.

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