Time to sell out of junk bonds
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Associate Editor
David Stevenson Aug 20, 2009
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Junk bonds historically have a bad name, but anyone who bought them early this year will be singing their praises. They've racked up a 60%-plus return this year alone, says Barclays Capital.
Even within the last three months, several UK corporate bond funds have managed to make their investors more than 25%.
That's a nice return if you've been on board. But if not, then now isn't the time to jump in. And in fact, it could well be time to sell...
How junk bonds work
First a quick recap on 'junk' bonds. Like any other bond, they're just IOUs issued by companies to raise cash. Most pay a fixed interest rate to 'redemption', i.e. when the company repays the money it's borrowed, at 'par' or face value.
After they've been issued, they are traded in the secondary markets, so you can buy these bonds above or below par, depending in part on the yield they offer and the risk that the underlying company might go bust.
Junk bonds are riskier than most, but they are still less risky than a company's ordinary shares, because interest must be paid on these bonds before dividends can be declared. But even so, last autumn, buying junk bonds didn't look such a great idea. The collapse of Lehman Brothers led to panic that the financial crisis would spawn a depression that would bankrupt many firms. This fear forced corporate bond yields up to their highest for 15 years.
In addition, new bond issues, which had been drying up since the back end of 2007, came to a complete halt. But that proved to be exactly the time to buy (for more on corporate bonds in general, read my colleague Tim Bennett's piece on investing in bonds from last November: Should you buy into corporate bonds?)
Increased demand for junk bonds is a worry
Life may still be tough in the 'real' world, with unemployment still rising, but in the financial markets, investors have got their mojo back. Much of the fear that was circulating several months ago has evaporated. As a result, European junk bond prices have rebounded strongly – up more than 60% this year, says Barclays Capital.
And demand is coming as a shock even to the issuers of the debt. For example, last Friday's FT noted that: "As €10bn ($14.28bn) in orders flooded in from investors for Italian carmaker Fiat's junk bond last month, even the company's bankers were surprised by the torrent of demand for a €1.25bn offering of risky debt. Just a few weeks earlier, such a deal might not have been possible".
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But this massive swing from gloom to boom-type thinking gets me worried. Here's the FT again: "Given this rebound, analysts are now taking a much more optimistic view about longer-term prospects. According to Barclays Capital, the European junk bond market is set to grow from €100bn currently to €150bn by the end of 2012".
This market bounce isn't about economic recovery – that's not really happening. Much of the world still revolves around America's consumers who account for 70% of the country's GDP. And the latest US retail sales report was "simply awful", as analyst and uber-bear David Rosenberg of Glusken Sheff puts it. Further, as we said in Money Morning recently (How savers could derail a recovery), even if there is a short-term pick-up, it probably won't last.
Investors now seem to think that the corporate bond market will keep going up mainly because it's already gone up. And when everyone turns bullish at the same time, it's generally a sell signal. As we said last week (Five reasons stock prices are set to drop), many share price levels are now a cause for concern for the same reason.
Andrew Sheets at Morgan Stanley points out that none of the previous bond recoveries going back to 1925 has been as dramatic as the latest. "Levels are almost back to where they were in the first quarter of 2008, but equities are still a long way off that", he says. He reckons junk bond prices are showing "signs of over-extension", i.e. they've risen too far for comfort.
The risk of holding junk bonds is rising
Over and above that, Sheets has also detected growing jitters in the credit options market, where investors can buy and sell bond derivatives. There's been a "sustained rise in implied volatility" - which measures the likelihood of prices moving up or down from a given point - in the September option contracts.
In plainer English, this means the risk of holding European junk bonds is rising. Yet interest rate spreads – the level of insurance demanded by buyers - on junk bonds, compared to government-issued debt, have continued to drop sharply. European junk bond spreads have dropped back to the long-term average despite the credit rating agencies still expecting a slew of defaults over the next two years. The number of defaults has already reached record levels, says S&P. Now junk bond yields are too low compared with stock market yields.
"Bond investors ignore this at their peril", says the Telegraph's Ambrose Evans-Pritchard. "Either stock markets will have to rise sharply – in doubt after poor US confidence data and jitters in the Shanghai markets as the Chinese authorities restrain lending – or credit spreads must start to widen again to reflect the risk".
In other words, junk bond prices are soon likely to fall again – which means it looks like time to sell out.
If you're looking for an alternative investment offering a decent yield, consider this. Five-year bonds issued by the German utility RWE yield just over 3% to maturity. But RWE's ordinary shares yield almost 6%. And RWE is one of several high-yielding utility stocks whose dividends look safe, as we pointed out in the magazine: Seven safe stocks that will last longer than the rally. (If you're not already a subscriber, claim your first three issues free here). If you don't mind being invested in the stock market, and taking the capital risk that this implies, and are looking for a good level of income, holding some of these utilities' shares could now be how to find it.
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