On Junk Bonds


If someone were to ask me my opinion on Junk Bonds at present, fool that he would be to ask me because I know real experts elsewhere, I would say this: They are good for a speculative trade, but dumb money has arrived.  Be ready to sell when the momentum fails.

High yield ETFs sell at decent premiums which leads to the creation of more units.  High yield closed-end funds — 73% trade at a premium.  You could issue a new high yield CEF, and come out at a lower premium than the current average.  I think I smell smoke.

Hmm….  If I owned junk bonds I would hold, and wait for momentum failure.  Buying now seems risky to me.  Most of the risk stems from global conditions.  We don’t know what will happen in the Eurozone. The rest of the risk stems from speculation.

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I am a fan of junk bonds when nobody likes them, but there are too many fans now, and for bad reasons, most of which boil down to “I am old and I need income.  The fed has eliminated good choices for income, but I need income anyway, so get me yield.”

I had a conversation with a friend of mine in her upper 70s today where she asked “why are you suggesting I sell my funds that provide the most income?”  I said that I did not trust junk bonds at present and would look to lighten up, besides, the fund she owned has underperformed over the last 10 years.  If she really wanted income from junk bonds, I would look for a new fund for her.  So I am looking for a new HY fund, with an arm twisted behind my back.  It’s not the right idea, but she won’t listen.  (She’s not paying me.  I help my friends as best I can.)

The illusion of yield drives many older investors; they need income, and the delusional Fed thinks that low yields will yield prosperity.  It may make some people take more risk, but it will not yield prosperity.  There will be a lot of impoverished old people at the end of this, and they will be angry — at themselves, their advisors,  and the powers that be.


This is not to say say that junk spreads are low; they are moderate to high at present.  But the spread relationship is manipulated by the Fed at present, making spreads seem high.  No market is truly free, but the Treasury market is affected by the Fed to a high degree.  The high quality bond market follows Treasuries closely.  Junk bonds don’t.  Junk bonds follow a hybrid of what Treasuries and common stocks are doing.  With stocks doing well, junk bonds run as well.

But we are still in an environment where more things can go wrong than right.  Until the US government figures out how to finance itself, we are in dangerous territory.  Given present political conditions, I don’t see how that works out; everything looks like a stalemate at present.

So be wary, and don’t overcommit to risk assets.  I would be neutral on risk assets at presemt, but ready to be bearish if there are problems in Europe or China.

David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.
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