Posts tagged ‘high yield’
Confessions of a Bond Hater
Source: stock.xchng
Hi my name is Wade, and I’m a bond hater. Generally, the first step in addressing any type of personal problem is admitting you actually have a problem. While I am not proud of being a bond hater, I have been called many worse things during my life. But as we have learned from the George Zimmerman / Trayvon Martin case, not every situation is clear-cut, whether we are talking about social issues or bond investing. For starters, let me be clear to everyone, including all my detractors, that I do not hate all bonds. In fact, my Sidoxia clients own many types of fixed income securities. What I do hate however are low yielding, long duration bonds.
Duration…huh? Most people understand what “low yielding” means, when it comes to bonds (i.e., low interest, low coupon, low return, etc.), but when the word duration is uttered, the conversation is usually accompanied by a blank stare. The word “duration” may sound like a fancy word, but in reality it is a fairly simple concept. Essentially, high-duration bonds are those fixed income securities with the highest sensitivity to changes in interest rates, meaning these bonds will go down most in price as interest rates rise.
When it comes to equity markets, many investors understand the concept of high beta stocks, which can be used to further explain duration. There are many complicated definitions for beta, but the basic principle explains why high-beta stock prices generally go up the most during bull markets, and go down the most during bear markets. In plain terms, high beta equals high octane.
If we switch the subject back to bonds, long duration equals high octane too. Or stated differently, long duration bond prices generally go down the most during bear markets and go up the most during bull markets. For years, grasping the risk of a bond bear market caused by rising rates has been difficult for many investors to comprehend, especially after witnessing a three-decade long Federal Funds tailwind taking the rates from about 20% to about 0% (see Fed Fatigue Setting In).
The recent interest rate spike that coincided with the Federal Reserve’s Ben Bernanke’s comments on QE3 bond purchase tapering has caught the attention of bond addicts. Nobody knows for certain whether this short-term bond price decline is the start of an extended bear market in bonds, but mathematics would dictate that there is only really one direction for interest rates to go…and that is up. It is true that rates could remain low for an indefinite period of time, but neither scenario of flat to down rates is a great outcome for bond holders.
Fixes to Fixed-Income Failings
Even though I may be a “bond hater” of low yield, high duration bonds, currently I still understand the critical importance and necessity of a fixed income portfolio for not only retirees, but also for the diversification benefits needed by a broader set of investors. So how does a bond hater reconcile investing in bonds? Easy. Rather than focusing on lower yielding, longer duration bonds, I invest more client assets in shorter duration and/or higher yielding bonds. If you harbor similar beliefs as I do, and believe there will be an upward bias to the trajectory of long-term interest rates, then there are two routes to go. Investors can either get compensated with a higher yield to counter the increased interest rate risk, and/or they can shorten duration of bond holdings to minimize capital losses.
Worth noting, there is an alternative strategy for low yielding, long duration bond lovers. In order to minimize interest rate risk, these bond lovers may accept sub-optimal yields and hold bonds to maturity. This strategy may be associated with short-term price volatility, but if the bond issuer does not default, at least the bond investor will get the full principal at maturity to help relieve the pain of meager yields.
Now that you’ve survived all this bond babbling, let me cut to the chase and explain a few ways Sidoxia is taking advantage of the recent interest rate volatility for our clients:
Floating Rate Bonds: Duration of these bonds is by definition low, or near zero, because as interest rates rise, coupons/interest payments are advantageously reset for investors at higher rates. So if interest rates jump from 2% to 3%, the investor will receive +50% higher periodic payments.
Inflation Protection Bonds: These bonds come in long and short duration flavors, but if interest rates/inflation rise higher than expected, investors will be compensated with higher periodic coupons and principal payments.
Shorter Duration: One definition of duration is the weighted average of time until a bond’s fixed cash flows are received. A way of shortening the duration of your bond portfolio is through the purchase of shorter maturity bonds (e.g., buying 3-year bonds rather than 30-year bonds).
High Yield Bonds: Investing in the high yield bond category is not limited to domestic junk bond purchases, but higher yields can also be earned by investing in international and/or emerging market bonds.
Investment Grade Corporate Bonds: Similar to high yield bonds, investment grade bonds offer the potential of capital appreciation via credit improvement. For instance, credit rating upgrades can provide gains to help offset price declines caused by rising interest rates.
Despite my bond hater status, the recent taper tantrum and interest rate spike, highlight some advantages bonds have over stocks. Even though prices declined, bonds by and large still have lower volatility than stocks; provide a steady stream of income; and provide diversification benefits.
To the extent investors have, or should have, a longer-term time horizon, I still am advocating a stock bias to client portfolios, subject to each investor’s risk tolerance. For example, an older retired couple with a conservative target allocation of 20%/80% (equity/fixed income) may consider a 25% – 30% allocation. A shift in this direction may still meet the retirees’ income needs (especially if dividend-paying stocks are incorporated), while simultaneously acknowledging the inflation and interest rate risks impacting bond positions. It’s important to realize one size doesn’t fit all.
Higher Volatility, Higher Reward
Frequent readers of Investing Caffeine have known about my bond hating tendencies for quite some time (see my 2009 article Treasury Bubble has not Burst…Yet), but the bond baby shouldn’t be thrown out with the bath water. For those investors who thought bonds were as safe as CDs, the recent -6% drop in the iShares Aggregate Bond Index (AGG) didn’t feel comfortable for most. Although I am still an enthusiastic stock cheerleader (less so as valuation multiples expand), there has been a cost for the gargantuan outperformance of stocks since March of ’09. While stocks have outperformed bonds (S&P vs. AGG) by more than +140%, equity investors have had to endure two -10% corrections and two -20% corrections (e.g.,Flash Crash, Debt Ceiling Debate, European Financial Crisis, and Sequestration/Elections). If investors want to earn higher long-term equity returns, this desire will translate into more volatility than bonds…and more Tums.
I may still be a bond hater, and the general public remains firm stock haters, but at some point in the multi-year future, I will not be surprised to hear myself say, “Hi my name is Wade, and I am addicted to bonds.” In the mean time, Sidoxia will continue to optimize its client bond portfolios for a rising interest rate environment, while also investing in attractive equity securities and ETFs. There’s nothing to hate about that.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs), including floating rate bonds/loan funds, inflation-protection funds, corporate bond ETF, high-yield bond ETFs, and other bond ETFs, but at the time of publishing, SCM had no direct position in AGG or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.
Private Equity: Hitting Maturity Cliff
Photo source: 1Funny.com
Wow, those were the days when money was as cheap and available as that fragile, sandpaper-like toilet paper you find at gas stations. Private equity took advantage of this near-free, pervasive capital and used it to the greatest extent possible. The firms proceeded to lever up and gorge themselves on a never-ending list of target companies with reckless abandon (see also Private Equity Shooting Blanks). Now the glory days of abundant, ultra-cheap capital are history.
Rather than rely on low-cost bank debt, private equity firms are now turning to the fixed income markets – specifically the high yield market (a.k.a. junk bonds). As The Financial Times points out, more than $170 billion of junk bonds have been issued this year, in large part to refinance debt issued in the mid-2000s that has gone sour due to overoptimistic projections and a flailing U.S. economy. In special instances, private equity owners are fattening their own wallets by declaring special dividends for themselves.
Even though some of these over-levered, private equity portfolio companies have received a temporary reprieve from facing the harsh economic realities thanks to these refinancings, the cliff of maturing debt in 2012 is fast approaching. Some have estimated that $1 trillion in maturing debt will roll through the market in the 2012-2014 timeframe. Either the economy (or operating performance) improves enough for these companies to service their debt, or these companies will find themselves falling off these maturity cliffs into bankruptcy.
Junk is Not Risk-Free
Driving this trend of loan recycling is risk aversion to stocks and a voracious appetite for yield in a yield desert. Stuffing the money under the mattress, earning next to nothing on CDs (Certificates of Deposit) and money market accounts, will not help in meeting many investors’ long-term objectives. The “uncertain uncertainty” swirling around global equity markets has nervous investors flocking to bonds. The opening of liquidity in the high yield markets has served as a life preserver for these levered companies desperate to refinance their impending debt. This high-yield debt refinancing window is also an opportunity for companies to lower their interest expense burden because of the current, near record-low interest rates.
But as the name implies, these “junk bonds” are not risk free. For starters, embedded in these bonds is interest rate risk – with a Federal Funds rate at effectively zero, there is only one upward direction for interest rates to go (bad for bond prices). In addition, credit risk is a concern as well. In the midst of the financial crisis, many of these high-yield bonds corrected by more than -40% from their highs in 2008 until the bottom achieved in early 2009. If the economy regresses back into a double-dip recession, many of these bonds stand to get pummeled as default rates escalate (see also, bond risks).
Pace Not Slowing
Source: Dealogic via WSJ
Does the appetite for high yield appear to be slowing? Au contraire. In the most recent week, Dealogic noted $15.4 billion in junk bonds were sold. The FT sees the pace of junk deals handily outpacing the record of $185.4 billion set in 2006.
The Wall Street Journal used the following deals to provide a flavor of how companies are using high-yield debt in the present market:
“First Data Corp. sold $510 million of 10-year notes this week, at 9.125%, to pay down bank debt due in 2014. Peabody Energy sold $650 million of 6.5%, 10-year notes to pay off the same amount of higher-priced debt due in three years. MultiPlan Inc., a health-care cost-management provider, sold $675 million of notes this week, at 9.875%, to help fund a buyout of the company. Cott Corp., a maker of store-branded soft drinks, sold $375 million of debt at 8.125% to fund its purchase of another company, Cliffstar Corp.”
The roads on the junk bond highway appear to be pothole free at the moment, however a cliff of debt is rapidly approaching over the next few years, so high-yield investors should travel carefully as conditions in the junk market potentially worsen. As we witnessed in 2008-2009, it can take a while to hit rock bottom in the riskier areas of the credit spectrum.
Read full Financial Times and Wall Street Journal articles on the high yield market.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
*DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds (including HYG and JNK), but at the time of publishing SCM had no direct position in First Data Corp., Peabody Energy (BTU), MultiPlan Inc., Cott Corp. (COT), Cliffstar Corp., or any security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
Getting Distressed can be a Beach
It was just another 65 degree winter day on the sunny shores of Huntington Beach at the 2nd Annual Distressed Investment Summit (March 1st through 3rd) when I entered the conference premises. Before digging into the minutiae of the distressed markets, a broad set of industry experts spoke to a diverse crowd including, pension fund managers, consultants, and hedge fund managers at the Hyatt Regency Huntington Beach Resort and Spa. The tone was somewhat restrained given the gargantuan price rebounds and tightening spreads (the premium paid on credit instruments above government securities) in the credit markets, nonetheless the tenor was fairly upbeat thanks to opportunities emanating from the still larger than average historical spreads.
Topics varied, but several speakers gave their views on the financial crisis, macroeconomic outlooks, general debt/credit trends, and areas of distressed credit opportunity. Like investors across all asset classes, many professionals tried to put the puzzle pieces together over the last few years, in order to provide a clearer outlook for the future of distressed markets. To put the addressable market in context, James Perry, Conference Chair and Investment Officer at the San Bernadino County Employees Retirement Association, described the opportunity set as a $2.5 trillion non-investment grade market, with $250-$400 billion in less liquid securities. Typically distressed securities consist of investments like bonds, bank debt, and/or CLOs (collateralized loan obligations), which frequently carry CCC or lower ratings from agencies such as Standard & Poors, Moodys, and Fitch.
As mentioned previously, since the audience came from a diverse set of constituencies, a broad set of topics and themes were presented:
- Beta Bounce is Gone: The collapse of debt prices and massive widening of debt spreads in 2008 and 2009 have improved dramatically over the last twelve months, meaning the low hanging fruit has already been picked for the most part. Last year was the finest hour for distressed investors because price dislocations caused by factors such as forced selling, technical idiosyncracies, and credit downgrades created a large host of compelling prospects. For many companies, long-term business fundamentals were little changed by the liquidity crunch. As anecdotal evidence for the death of the beta bounce, one speaker observed CLOs trading at 30-35 cents during the March 2009 lows. Those same CLOs are now trading at about 80 cents. Simple math tells us, by definition, there is less upside to par (the bond principal value = 100 cents on dollar).
- Distressed Defaults: Default rates are expected to rise in the coming months and years because of record credit issuance in the 2006-2007 timeframe. The glut of questionable buy-outs completed at the peak of the financial markets driven by private equity and other entities has created a sizeable inventory of debt that has a higher than average chance of becoming distressed. One panel member explained that CCC credit ratings experience a 40% default within 5 years, meaning the worst is ahead of us. The artificially depressed 4-7% current default rates are now expected to rise, but below the 12% default rate encountered in 2009.
- Wall of Maturities: Although the outlook for distressed investments look pretty attractive for the next few years, a majority of professionals speaking on the topic felt a wave of $1 trillion in maturities would roll through the market in the 2012-2014, leading to the escalating default rates mentioned above. CLOs related to many of the previously mentioned ill-timed buyouts will be a significant component of the pending debt wall. Whether the banks will bite the bullet and allow borrowers to extend maturities is still an open topic of debate.
- Mid Market Sweet Spot: Larger profitable companies are having little trouble tapping the financial markets to access capital at reasonable rates. With limited capital made available for middle market companies, there are plenty of opportunistic investments to sift through. With the banks generally hoarding capital and not lending, distressed debt investments are currently offering yields in the mid-to-high teens. Borrowers are effectively beggars, so they cannot be choosers. The investor, on the other hand, is currently in a much stronger position to negotiate first lien secured positions on the debt, which allows a “Plan B,” if the underlying company defaults. Theoretically, investors defaulting into an ownership position can potentially generate higher returns due forced restructuring and management of company operations. Of course, managing the day-to-day operations of many companies is much easier said than done.
- Is Diversification Dead? This question is relevant to all investors but was primarily directed at the fiduciaries responsible for managing and overseeing pension funds. The simultaneous collapse of prices across asset classes during the financial crisis has professionals in a tizzy. Several diversification attacks were directed at David Swensen’s strategy (see Super Swensen article) implemented at Yale’s endowment. Although Swensen’s approach covered a broad swath of alternative investments, the strategy was attacked as merely diversified across illiquid equity asset classes – not a good place to be at the beginning of 2008 and 2009. The basic rebuttal to the “diversification is dead mantra” came in the form of a rhetorical question: “What better alternative is there to diversification?” One other participant was quick to point out that asset allocation drives 85% of portfolio performance.
- Transparency & Regulation: In a post-Bernie Madoff world, even attending hedge fund managers conceded a certain amount of adequate transparency is necessary to make informed decisions. Understanding the strategy and where the returns are coming from is critical component of hiring and maintaining an investment manager.
- Distressed Real Estate Mixed Bag: Surprisingly, the prices and cap rates (see my article on real estate and stocks) on quality properties has not dramatically changed from a few years ago, meaning some areas of the real estate market appear to be less appealing . Better opportunities are generally more tenant specific and require a healthy dosage of creativity to make the deal economics work. Adjunct professor from Columbia University, Michael G. Clark, had a sobering view with respect to the residential real estate market home ownership rates, which he continues to see declining from a peak of 70% to 62% (currently 67%) over time. Clark sees a slow digestion process occurring in the housing market as banks use improved profits to shore up reserves and slowly bleed off toxic assets. He believes job security/mobility, financing, and immigration demographics are a few reasons we will witness a large increase in renters in coming periods. Also driving home ownership down is the increased density of youngsters living at home post-graduation. Clark pointed out the 20% of 26-year olds currently living at home with their parents, a marked increase from times past.
Overall, I found the 2nd Annual Distressed Investment Summit a very informative event, especially from an equity investor’s standpoint, since many stock jocks spend very little time exploring this part of the capital structure. Devoting a few days at the IMN sponsored event taught me that life does not have to be a beach if you mix some distress with a little sun, sand, and fun.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at time of publishing had no direct position on any security referenced. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
Misery Loves Company – Ruler Waffling
Besides using a ruler for measuring small distances and rapping disobedient knuckles, the wooden instrument can also be used for extrapolating trends. This ruler is a very convenient tool when rigorous analysis is a second choice.
Misery loves company, so the often maligned pool of inaccurate Wall Street equity analysts are happy to share the limelight with their trend leaning junk bond analyst cousins. As default rate expectations have bounced around like a jack rabbit post the Lehman Brothers bankruptcy, these bond forecasters have been caught flat-footed.
Reuters highlighted the backpedaling of Standard & Poor’s recent forecast changes:
“S&P said it now expects defaults to decline to 6.9 percent a year from now from a September rate of 10.8 percent. On Oct 2, it had said it expected defaults to escalate to 13.9 percent by August 2010.”
For a lazy analyst, extrapolation is a good fall-back strategy. Sticking your neck out by looking out further into the future or grasping the concept of reversion to the mean can be difficult and politically risky from a job retention perspective. It’s much easier to constantly hug current trends because it then becomes virtually impossible to be wrong.
Just as the rating agencies contributed to the subprime and auction rate securities (ARS) debacles by rubber stamping their AAA approvals last year through the financial crisis, so too have we witnessed the failure of bond analysts to properly analyze junk bond default rates.
Hopefully the narrowing of credit spreads is a leading indicator for economic improvement, but regardless the number and amount of high yield deals hitting the market is flowing heavily. The Wall Street Journal recently reported billions of junk bond deals being priced this week and next, including the $500 million Crown Castle International’s 10-year deal; $200 million Mohegan Tribal Gaming’s eight-year bonds; $325 million in Headwaters Inc.’s five-year notes; and over $2.4 billion of bonds from four other borrowers, including Boise Paper Holdings, Reynolds Group, Murray Energy Corp. and Universal City Development.
As larger companies are freely tapping the capital markets for capital, it’s becoming more and more evident that small businesses are having tougher and tougher times accessing credit, thanks in large part to banks hunkering down and reducing lending. Reference the flattening commercial bank credit curve chart provided by the Federal Reserve System:
As we watch the credit flow drama unfold in these uncertain economic times, don’t panic if you wondering what will happen next. Just reach into the desk drawer and pull out the favorite tool of Wall Street equity and junk bond analysts…the righteous ruler.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management and its client accounts do have direct positions in HYG shares at the time this article was originally posted. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
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