Tags: gil | shidlo | junk | bonds

Shidlo: Return of Junk Bonds Means Higher Risk

By    |   Monday, 11 Oct 2010 09:34 AM

The year 2010 saw a surge in the issuance of high yield bonds or “junk” bonds, topping $200 billion during the first three quarters of the year.

With yields on Treasury bonds at a ridiculous historic low — the two-year yielding 0.26 percent; the five-year 1.1 percent; and the 10-year government bond 2.39 percent — it is no wonder that investors are pouring money into junk bond mutual funds.

Meanwhile, high-yield bond funds return over 12 percent. The average investor who is still burnt from the crashes on Wall Street considers this less risky than the S&P 500 or the Nasdaq right now. A high-yield bond is a bond that is rated below investment grade (below BBB- by S&P and below Baa3 by Moody’s) at the time of purchase.

These bonds pay higher yields as they have higher risk of default. The risk of such bonds is not only credit risk but also interest rate risk, that is, the risk of interest going higher.

What the average investor seems to have forgotten is what happened in the 1980s, the so-called “decade of greed,” when junk bonds were used for leveraged buyouts. By the 1990s, default rates of high-yield debt increased sharply, to nearly 10 percent.

For quite a long time, people avoided buying these types of bonds, but those blessed with short memories seemed to have boosted their revival.

Some reports are quick in pointing out that this time it’s different from the Michael Milken era, when junk bonds were used to finance buyouts. They sometimes forget, however, to mention that what is happening now is that the money being raised by these junks bonds is not always used to refinance debt or for investment.

Refinancing debt at higher interest rates makes sense and gives a positive push to any company. However, what does not make sense from an investor’s point of view, is issuing junk bonds — some with long maturities — to pay a large dividend to private equity firms. For instance, private equity firms that take over companies with debt might later on re-leverage companies as they extract payouts.

When investing directly in a high-yield bond, one can look at the prospectus and find out if the funds raised will be used to increase shareholder value or instead be paid out to private equity firms.

When one invests in a high-yield bond fund, though, one has to depend on the management of the fund. It is not clear whether high-yield bond fund managers would object to investing in a bond which would only further leverage the company rather than paying off expensive debt or using it to takeover another company.

Maybe investors who cannot buy individual high yield bonds (and some of them are worth investing in) should listen to Warren Buffett when he says that now is the time to invest in stocks rather than bonds.

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The year 2010 saw a surge in the issuance of high yield bonds or junk bonds, topping $200 billion during the first three quarters of the year. With yields on Treasury bonds at a ridiculous historic low the two-year yielding 0.26 percent; the five-year 1.1 percent; and...
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2010-34-11
Monday, 11 Oct 2010 09:34 AM
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