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Learn how to find and invest in undervalued stocks from the market insider that MSN Money’s Michael Brush calls one of his “favorite value managers for the past decade.”, George Putnam III.

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George Putnam
By
July 02, 2019

High Yield Bonds - Into Thin Air?

With investors’ faith in the long-running economic expansion and bull market being tested, we thought some comments on high yield bonds would be of interest to turnaround investors. Companies with these bonds, sometimes referred to as “junk bonds,” often are, or probably should be, in turnaround mode. And, if the companies eventually file for Chapter 11 bankruptcy, they can provide appealing distressed bond or post-bankruptcy stock opportunities. Given their riskier nature, high yield bonds tend to behave more like stocks than other, higher quality bonds.  


Over long periods of time, high yield bonds have produced attractive returns. The 10-year annualized return of the S&P U.S. High Yield Corporate Bond Index, at 10.6%, has nearly kept pace with the S&P500 Index (at 13.1%). Yet, returns tend to be cyclical, and when these cycles end, they usually end poorly. 

 

In the current cycle, U.S. corporate debt has reached nearly 46% of GDP, a record. As the graph on the next page shows, a staggering amount of high yield debt has been issued over the last nine years. And as the graph also shows, periods of strong high yield issuance have historically been followed by periods of high levels of default and bankruptcy. If defaults do pick up, as the graph suggests, re-turns on high yield debt will be poor for a while. 

 

Another indicator of whether high yield bonds are attractive is their yield relative to risk-free U.S. Treasury bonds. The wider this “yield spread,” the more investors get paid to take on the extra risk. During calm and prosperous periods, high yield spreads can be be-low 4 percentage points. Yet, when defaults increase, these spreads can widen into double digits. How do spreads widen? Bond prices fall. With spreads currently at about 4.4 points, the upside in these riskier bonds is limited, while the downside could be sizeable. 

 

For turnaround investors looking at high yield bonds, this is a time to be cautious. Companies with credible business plans and reasonably good prospects may have appealing bonds. But, in general, the high yield sector looks unlikely to continue its strong performance and now carries increased risk. Investors should wait for the cycle to turn downward, then look for bargain prices in distressed bonds and newly emerged post-bankruptcy stocks. 

 

 

BANKRUPTCY-ASSETS-VS-HIGH-YIELD-ISSUANCE

 

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In the current cycle, U.S. corporate debt has reached nearly 46% of GDP, a record.