By Ben Strubel of Strubel Investment Management

3/17/2014

Over the past several years, when reviewing portfolios for clients, I have seen many with substantial allocations to junk bond funds. In most of the cases it’s a client looking for a conservative income generating portfolio. In other cases I have seen junk bonds included as part of a diversified portfolio for investors looking for growth. I disagree with allocations to broad junk bond funds in portfolios and especially now given the current dynamics in the junk bond market. Thus I’ve decided to name junk bond funds Strubel Investment Management’s Dumb Investment of the Week.

Before we go any further I want to point out that for this article I’m referring specifically to broad diversified junk bond funds whether actively or passively managed such as iShares iBoxx $ Hugh Yield Corporate Bond Fund (HYG), SPDR Barclays Capital High Yield Bond ETF (JNK), or PowerShares High Yield Corporate Bond Portfolio (PHB) and not selective distressed debt investing.

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The Logical Conundrum with Junk Bonds

One of the things that I find fascinating is the implied logic behind investing in junk bonds. Investors are buying the debt of companies with suspect finances. Standard & Poors defines BB debt, the highest of the junk grades, as:

An obligor is LESS VULNERABLE in the near term than other lower-rated obligors. However, it faces major ongoing uncertainties and exposure to adverse business, financial, or economic conditions which could lead to the obligor’s inadequate capacity to meet its financial commitments.

In exchange for taking on more risk junk bond buyers are compensated with higher interest rates. Debt investors take solace in the fact that they are usually first or close to it in line in the capital structure to get paid, thus the thinking goes that junk bonds should be less risky then equity investments. My question to junk bond investors is why would you want to invest in companies “facing major ongoing uncertainty” and with possibly precarious finances at any point in the capital structure? Why not invest at a lower point (in the equity) of the capital structure of financially sound companies and earn your risk premium that way?

Is Junk Bond Investing Worth the Risk?

Let’s start with trying to answer the question “are investors being adequately rewarded for investing in the debt of less financial sound companies?”

I wanted to look at the returns of junk bonds versus other combinations of assets. For junk bonds I used the Barclays High Yield Bond Index returns from 1983 to 2012, for stocks I used the S&P 500 index from 1983 to 2012, and for a safe asset I used the return for 10 year treasury bonds again from 1983 to 2012.

From 1983 to 2012 junk bonds had average compounded annual returns of 9.27% and a standard deviation of 15.74%. What’s interesting is how various portfolios made up of risky assets (stocks) and very safe assets (T-bonds) stack up.

The table below shows how the asset classes compare to a portfolio of 50% stocks and 50% T-bonds and 75% stocks and 25% T-bonds.

Junk Bonds S&P 500 T-Bonds 50/50 75/25 Average Annual Return 9.27% 10.06% 8.13% 9.61% 9.98% Standard Deviation 15.74% 17.24% 9.66% 9.73% 13.07% Max Yearly Drawdown -26.16% -37% -11.12% -8.45% -22.75%

We can see some interesting things. A 50/50 split between T-bonds and stocks gives us returns that exceed junk bonds and has lower volatility (standard deviation). What is interesting is that the maximum drawdown an investor would experience in any one calendar year is only 8.45%. This is well below the 26.16% maximum yearly drawdown for junk bonds but it’s even below that of just T-bonds. The 75/25 split also out performs junk bonds with lower volatility and lower yearly draw downs.

This is why I advocate that for the safe portion of your portfolio put it in truly safe and conservative assets and for the risky portion make sure you are taking risk intelligently.

Reach for Yield

Despite the fact that over the past 30 years junk bonds have not offered investors anything that couldn’t be accomplished by an intelligent stock and investment grade bond split they continue to pile money in to junk bond funds.

Companies have been more than happy to attempt to satiate investors demand for this type of debt and high yield bond issuance has exploded the last several years.

(Graphic source: Forbes)

What makes this trend even more concerning is the worrying fact that debt covenants are getting less restrictive.

Moody’s recently reported that the quality of covenants on high yield bonds hit a record low. It appears that investors are letting the quest for yield get in the way of sensible debt contracts.

Another alarming issue is that much of the performance of broad high yield bond funds appears to be driven by so called “fallen angels”. Fallen angel bonds are debt that started out as investment grade but have since been downgraded in to junk territory. There have been numerous studies that show investing in fallen angel bonds can provide attractive risk adjusted returns. Below is an excerpt from Van Eck Global that shows the returns of fallen angel bonds versus other types of high yield debt.

While the maximum drawdown and volatility is similar to broad based junk bond indices at least investors are being compensated with higher returns.

But, as we saw in the first part of this section the high yield market is becoming increasingly flooded with new junk debt that is starting life off with a below investment grade rating. As more of this newly issued junk debt fills up the broad high yield bond indices the more attractive fallen angel debt will receive lower and lower allocations in the index.

Summary

Despite their popularity I see no reason why the sensible investor should make high yield bonds a part of their portfolio. The risk adjusted returns appear to be inferior to that of a diversified portfolio of stocks and T-bonds. Furthermore the deterioration of credit quality and the record debt issuance amounts raises the question of whether a bubble is brewing in the high yield debt market. It’s prudent to remember that increasingly lax lending standards and insatiable appetite for mortgage securities preceded the subprime mortgage bubble. Investors would be wise to consider what effects a slowing economy or rising interest rates might have on the ability of high yield junk bond issuers to service or rollover their debt.

If investors insist on investing in high yield debt, fallen angel bonds or bond funds have historically been shown to provide more attractive returns.