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The Case for High-Yield Bonds

FORECASTS & TRENDS E-LETTER
by Gary D. Halbert
September 15, 2009

IN THIS ISSUE:

1.  “Junk Bond” Basics

2.  High-Yield Bond Whitepaper
by Steven D. Landis, CFP

3.  Is the Party Over for 2009?

4.  Introducing the Columbus High-Yield Bond Program

5.  Performance Evaluation

6.  Conclusions

Introduction

High-yield bonds, or “junk bonds” as they are widely known, have become the subject of quite a bit of attention in recent months.  That’s because, as of August 31st, the Barclays and Merrill Lynch high-yield bond indexes have jumped over 40% in value so far in 2009.  This makes the S&P 500 Index’s year-to-date return of only 14.97% as of August 31st paltry in comparison.

Returns of that magnitude have not escaped the notice of investors.  Inflows into high-yield bond mutual funds have been at or near record levels since March, based on information from AMG Data Services, a mutual fund tracking firm.  However, the question is whether the good times in high-yield bonds will last.

I certainly don’t pretend to be an expert on high-yield bonds, but I have found that the cyclical trends in the high-yield market often do lend themselves to being traded by an active money manager.  Though “junk bonds” carry with them the reputation for being risky (and they are), we have found a professional money manager who has produced an enviable track record with low historical drawdowns.

This week, I’m going to feature Sojourn Financial Strategies, LLC and its co-founder, Steven D. Landis, CFP.  I’ll begin by reprinting excerpts from a whitepaper on high-yield bonds that Steve has authored.  This paper does an excellent job of explaining the opportunities available in high-yield bonds, and whether or not it’s too late to participate in the junk bond rally that began earlier this year. 

I’ll then finish up by presenting Steve’s Columbus High-Yield Bond (CHYB) Program.  Just to whet your appetite, this actively managed strategy has produced an annualized return of over 10% since its inception in 2002, with a maximum drawdown of only -6.14%.  Year-to-date, the CHYB Program is up over 24% as of the end of August.  Past performance, however, is not necessarily indicative of future results.

Junk Bonds 101

Most of us realize that high-yield bonds are called “junk bonds” because they carry a much higher risk of default than government or high-grade corporate bonds.  As a result, these bonds tend to carry a higher rate of interest in order to compensate investors for taking on a greater risk of default.  Like all bonds, high-yield issues tend to be affected by the interest rate climate.  However, what you may not know is that the value of a high-yield bond can also be affected by the health of the economy and stock market. 

It just makes sense that a better economic environment sometimes reduces a junk bond’s default risk, since the issuing corporation may be less likely to default in a good economy.  As a result, the spread between the effective junk bond yield and a risk-free (Treasury) rate closes, and the underlying bond becomes more valuable.

Of course, the skill in managing high-yield bonds or junk bond mutual funds comes in knowing when to be in the market and when to move to cash.  Since 2002, Steve has shown us that he has the methodology in place to make these decisions with a high degree of accuracy.  However, before getting into the details of his program, I want to reprint excerpts from his recent whitepaper on high-yield bond investing.

QUOTE:

Investors Ready for a New Way to Invest in High Yield Bonds
By Steven D. Landis, CFP®

High yield bonds have been around for longer than most of us can remember.  Anybody who was born earlier than 1960 can recall the days of Ivan Boesky and Michael Milken, the highly creative and somewhat dubious creators of “junk bonds” (the more-to-the-point term for high yield bonds).  Eventually, their actions, not the junk bonds, landed the boys in jail for a short time.  It should be noted that never was there (then or now) anything illegal about the use of the junk bonds, but their criminal activity, in part, contributed to the bad reputation sometimes attributed to high yield bonds.

In this paper, the terms high yield bonds, junk bonds, and “junks” will be used interchangeably and will have the same meaning and reference.  These terms apply to loans that are made to higher risk, corporate borrowers of money.  High yield bonds had been in existence long before Boesky’s and Milken’s involvement in the early 1980s.  During the early part of the 20th century General Motors, U.S. Steel, and other well-known corporations borrowed money that, at that time, was considered higher-risk debt.  If that debt were issued today, it would be considered to be a junk bond. 

Fast forward to today and we find that more than $500 billion (a half-trillion dollars) defines the magnitude of the high yield bond market.  Its explosive growth is the result of two factors:  1) more companies needing capital; and 2) the availability of investors who are willing to take more risk in return for a higher yield on their investment.

Bond Ratings

Bonds are rated based on the probability of the borrower defaulting on the bond, that is eventually failing to meet the terms of the bond covenant.  The highest quality bonds, those with the greatest probability of paying back the loan principle and interest, are rated AAA.  As the chances of a bond default increases, the lower the rating on the bond, as illustrated in Table 1 below.

Table 1.
Bond Rating vs. Default Risk

Standard & Poor’s Rating

Grade

Default Risk

AAA

Investment

Lowest Risk

AA

Investment

Low Risk

A

Investment

Low Risk

BBB

Investment

Medium Risk

BB, B

Junk

High Risk

CCC, CC, C

Junk

Highest Risk

D

Junk

In Default

So we can see that the two terms used to describe these bonds, high-yield and junk, come from two features of the bonds: 1)  High-yield refers to the increased interest rate that accompanies the bonds; and 2)  Junk refers to the low quality of the bond.

Risks of investing in high yield bonds

In 2007, investors and the public became intimately familiar with the sub-prime consumer mortgages and their risk to lenders (and ultimately the economy, in general).  The results of consumers overextending themselves by borrowing more debt than they could repay, under terms that were unfavorable, eventually resulted in a near-collapse of the consumer mortgage market.  Investors in those sub-prime mortgages soon found their investments suffering tremendous losses.  Meanwhile, the ability to sell out of those investments became more and more difficult due to a lack of buyers.  A similar scenario also played out in the high yield bond market in which holders of low-quality debt saw their investments lose a substantial percentage of its original value.

A fact of life is that consumers with low credit scores must pay high interest rates when they borrow money.  This higher interest rate compensates the lender for the increased chance of the borrower defaulting on the loan.  Likewise, corporate borrowers with a lower credit rating have an increased probability of defaulting on their loans and pay lenders accordingly.  Those who loan money to these corporate borrowers demand to be compensated for the extra risk they take in making these loans.  Should a default occur, the bondholders stand in line with all the other creditors of the company, hoping to get back some portion of their money.  The lower the quality the bond, the less chance there will be assets that can be used to pay back creditors.  The increased interest rate compensates the lender, at least in part, for this additional risk.

The result is that those entities that lend money to higher risk borrowers, via junk bond offerings, receive a higher interest rate than if they had been lending money to higher quality (lower risk) borrowers.  To illustrate this difference, consider that over the past twenty or so years, high yield bonds have paid an interest rate of 3-9% (with an average of 6%) per year more than that of U.S. Treasury bonds.  This difference is known as the “spread.”  In early 2008 the average default rate on junk bonds was about 1.1%.  However, as the economy continued to sour the default was expected to increase to around 5.2%.  Compare this with an average, long-term default rate of about 4.9% (according to John Lonski, chief economist of Moody’s.)

An additional risk of junk bonds is their lack of liquidity.  Liquidity refers to the ease of trading the instrument in the marketplace.  The author of this paper also refers to liquidity as “how quickly one can sell an investment and convert it to cash”.  Junk bonds are not traded as freely as, say, government bonds.  Thus, the liquidity of high yields is significantly lower than that of high quality debt, which leads to higher costs of trading and selling at one’s desired price.  All of these factors combined result in the higher interest rate that is attached to junks.

Why Invest in High-Yield Bonds?

Unlike normal bonds, that are greatly influenced by fluctuations in interest rates, junk bonds are less affected by interest rate movement.  This is because junks generally have higher interest rates and have, generally, shorter maturities.  In fact, junk bonds are affected more by overall economic changes (expansion or contraction) than changes (increase or decrease) in prevailing interest rates.  This is because the quality of a junk bond is most affected by the strength of the company issuing the bond.

If the company’s profitability increases (since the issuance date of the bond), the quality of their bonds increases.  For an investor in a junk bond, this is an almost-perfect scenario:  One in which a junk bond with a high interest rate becomes a quality bond with a high interest rate (this being the result of the formerly high risk borrower becoming a low risk borrower). 

For example, ABC Corp. had a debt rating of “B” and issued a bond at 12%.  Meanwhile, AAA-rated debt was paying 4%.  Sometime following issuance of this debt, ABC Corp. enjoys a return to profitability and its debt rating is upgraded to “A”.  The result is that holders of those old ABC Corp. bonds now hold A-rated debt that is paying 12%!  This, in turn, makes the underlying bond more valuable since investors are willing to accept a lower rate of interest on debt issued by a stable company.

How to Invest in High-Yields

In my opinion, investing directly in individual junk bonds should be left to the wealthy and institutional investors.  In fact, the majority of investors in junk debt are institutional…mutual funds, pension funds, hedge funds, and others.  This, however, does not suggest that investing in junks is only for the wealthy.  Most all investors can get involved with junk bond investing by investing in mutual funds that specialize in them. 

By investing in a mutual fund that specializes in junk bonds, an investor can take advantage of a professional fund manager.  Additionally, the investor will be able to reduce risk via the diversification that mutual funds offer.  (A typical mutual fund will hold as many as 200-400 bonds, all of which are owned, on a pro rata basis, by investors in the fund.)

Keep in mind, though, that investing in a mutual fund does not mean that the investor has no risk.  Like the bonds held by the fund, a mutual fund can gain or lose value.  Plus, in the event of a slowing economy, high yield bond mutual funds can lose significant value.  So, for anybody considering an investment in high yield bond funds (or for that matter, any mutual fund) consider your tolerance for and ability to withstand potential losses. 

An Improvement on Buy-and-Hold Bond Investing

As much as we really like investing in high-yield bond funds, they have one major flaw.  That flaw is that there are times in which high yield bonds (and mutual funds investing in them) will get absolutely annihilated in a bear market.  The years 2007 and 2008 are the most recent examples of this.  In 2008, the majority of high yield bond mutual funds lost more than 20% of their value.  Worse still were those funds that lost more than 50% of their value!

Risk-averse investors may find themselves asking:  “Is there a way to invest in high yield bond funds without the risk of losing money in a down market?”  Fortunately, the answer is, “Yes, there is.”  There are any number of advisers whose role is to actively manage money for their clients.  (The author of this paper is among those who manage money for investors who want to invest in high yield bond funds.)  The goal for most of these advisers/managers is to be invested in a security/market when it's gaining in price and to sell that security/market before its price goes down too much.

If the adviser is able to do this buying and selling successfully (and we emphasize “IF”), then that adviser’s clients/investors would be able to make more profit while taking less risk.  By reducing the losses during time periods in which high yield bonds are losing money (1998-2002 and 2007-2008) one can dramatically improve the potential for long-term profits.

Is the Party Over for 2009?

At this point, readers of this paper are either eager to invest in high-yield bond funds or skeptical and not interested in the increased risk.  For those who are tempted to invest in the high-yield bond market, a question arises: “How much profit is left after the big run junks have had this year?”

It goes without saying that we have no idea how much more high yields can offer.  But we can offer a look at three possible scenarios:

Scenario 1.  The Economy Improves.  If the economy continues to improve, profits of most corporations will rise.  At the same time, we would expect profits of many issuers of high yield debt to improve.  If this scenario does, in fact, occur then we would expect high yield bonds to continue increasing in price.  (Additionally, bondholders would continue to receive interest payments from those bonds.)

Scenario 2.  The Economy Sours.  If the economy begins to worsen, then corporate profits will likely be depressed.  At the same time, profits of issuers of high yield debt would probably suffer.  In this scenario, the prices of high-yield debt would probably begin to fall.  The buy-and-hold investor would suffer losses to his/her investment.  Investors who use skilled, successful active managers have a great probability that their adviser/manager would sell their junk bond fund and invest their money in the safety of a money market fund.  This move to safety would preserve the value of investors money.

Scenario 3.  The Economy Muddles Along.  If the economy becomes listless and neither grows nor contracts, there is the possibility that high-yield bond prices could stagnate.  That is, prices would neither rise nor fall.  It would be extremely rare for this to continue for an extended period of time, but let’s assume it does.  In such a situation, the investor neither gains nor loses money on his/her investment principle.  However, he/she could continue to reap profits in the form of high interest income being generated by the bonds.

So, looking at the three possible scenarios, the only one that we would expect to pose a threat of significant loss is Scenario #2, specifically for the buy-and-hold investor.  The investor who uses a skilled, active adviser/manager has a significantly greater chance of avoiding losses during a “down market”.  [There are no guarantees, of course. GDH]

In summary, we contend that high yield bond mutual funds can be an extremely attractive way to invest, though subject to substantial losses during falling markets.  Furthermore, we believe that investing in high yield bond mutual funds can be an even more attractive method of investing, if managed under the guidance, direction, and oversight of an experienced and skilled adviser.

Steven D. Landis, CFP®
Sojourn Financial Strategies, LLC

References:

  1. Glenn Yago. “Junk Bonds.”  The Concise Encyclopedia of Economics.  2008.  Library of Economics and Liberty.  Retrieved December 20, 2008 from the World Wide Web: http://www.econlib.org/Library/Enc/JunkBonds.html
  2. John Waggoner. USA Today. February 7, 2008.
  3. “Junk Bonds: Everything You Need to Know”. Investopedia®

END QUOTE

The Columbus High-Yield Bond Program (CHYB)

As Steve made clear in his whitepaper, active management of high-yield bond mutual funds can potentially allow investors to participate in both capital gains and coupon returns, while also moving to the sidelines during times of downward price pressure.  This ability to move to cash in downward trending markets is very important, especially considering the aggressive nature of high-yield bond investments.

It might come as a disappointment that the CHYB Program is up “only” 25.01% so far in 2009 as of August 31, considering that the Barclay’s High-Yield Credit Bond Index is up over 40% over the same period of time.  However, this analysis is very short-sighted given that historical drawdowns in the Barclay’s Index have exceeded -33%, while the CHYB’s worst-ever drawdown has been limited to just over -6%.

The value of minimizing losses becomes even more apparent when looking at the rolling 5-year returns as of August 31.  The CHYB Program has a 5-year annualized return of 8.94% while the unmanaged Barclays Index has managed an annualized return of only 5.27%.  Again, the ability to move to cash in downward trending markets can make a significant difference in long-term returns, though there are no guarantees.  And remember that the CHYB returns are net of all fees and expenses.

The Columbus High-Yield Bond Trading Strategy

Steve’s proprietary trading model uses technical indicators to determine the high-yield bond market’s potential future movements.  However, Steve goes one step further by analyzing the technical indicators unique to each of the high-yield bond mutual funds he uses.  Like many other active money managers, Steve will sometimes use specialized high-yield bond index funds.  However, he also uses traditional high-yield bond funds when his system tells him they have the best potential for future gain. 

Doing this allows him to combine his market timing expertise with the bond selection expertise of the mutual fund manager.  Plus, traditional high-yield bond funds typically pay a higher “coupon” rate of return than specialized index funds.

As a general rule, the CHYB Program invests in only one mutual fund at a time, though future growth may require him to use two or more funds.  Client accounts will either be 100% in a high-yield mutual fund or 100% in cash (money market); there are no graded investments or partial positions taken.

The CHYB trading model does not use leveraged funds nor does it use specialized inverse funds that provide a net “short” exposure to the high-yield bond market.  However, Steve may use such inverse funds as a hedge under certain conditions.  Best of all, Steve’s strategy employs the use of trailing stop orders that close out trades should losses exceed a pre-determined percentage.  In winning trades, these stop-loss orders ratchet up with gains, providing the potential to lock in any positive returns over and above the stop-loss trigger percentage.

If I had to describe our observations of Steve’s trading model, I’d have to use the term “patience.”  Steve does not employ any discretion in his trading, so he will allow the system to stay in cash as long as necessary until the high-yield bond market environment improves.  For example, the CHYB Program was in cash for much of 2008, which is why it ended the year with only a 2.9% loss rather than a drop of over 26% as was the case in the Barclays High-Yield Credit Bond Index.

Performance Evaluation

The goal of the CHYB Program is not necessarily to “beat the market” over the short run, but rather to participate in market gains while also managing risks.  From the historical performance statistics provided below, it is evident that Steve has attained this goal in the past, though past performance cannot guarantee favorable future results:

Performance Statistics
(Net of all fees and expenses)

 

 

 

PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.
(Please see Important Disclosures below.)

The CHYB Program is available through the Purcell Advisory Services platform.  Accounts are held at Trust Company of America (TCA), an independent trust company located in Denver, Colorado.  Clients have online access to their accounts via the TCA website.  Both TCA and Purcell issue quarterly statements and TCA produces year-end tax reports.  TCA charges a custodial fee of 1/10th of one percent (ten basis points) of the account balance.

The minimum account size for the CHYB Program is $50,000 per account.  Management fees are billed quarterly in advance based on the following annual percentages for various sized accounts:

First $500,000

2.50%

$500,000 to $1 million

2.25% (entire account)

$Over $1 million

2.00% (entire account)

It is important to remember that all performance information provided above is net of both the management fee and custodial fee charged on the accounts.

Conclusions

We have been offering the Columbus High-Yield Bond Program for over three years now, and I continue to be impressed with the way it can participate in market gains and then move to the safety of the money market fund when the risk of loss becomes too great.  I also like the fact that it is a non-discretionary system, which is an important factor when the model has been in cash for an extended period of time.

Over the years, I have seen money managers disregard their trading systems when they signal to be in cash for weeks or months.  Overriding a trading system can also result from clients calling to ask why they are paying a fee to sit in a money market fund.  Steve stuck to his guns during the extended cash position in 2008, and we haven’t heard many clients complaining about having lost only 2.9% for the year when the stock and high-yield bond markets were in free-fall.

While you may have missed much of the move in high-yield bonds so far in 2009, I think Steve makes a good case for investing in this program now.  Since we recommend this program for investors with at least a three-to-five-year time horizon, we feel that the CHYB Program’s combination of market participation and risk management is a fit for the less aggressive portion of your portfolio.  As always, be sure to read all offering materials and Important Disclosures before making a decision to invest.

If you would like to learn more about the Columbus High-Yield Bond Program or any of our other risk-managed AdvisorLink® investment programs, please feel free to give one of our Investment Consultants a call at 800-348-3601 or click on the following link to complete one of our online request forms.  If more convenient, drop us an e-mail at info@halbertwealth.com or visit our website at www.halbertwealth.com to learn more about this and our other actively managed investment strategies.

Special Reminder about the “All They’ll Need to Know” Booklets

As I mentioned a couple of weeks ago, we have now exhausted our supply of the end-of-life planning resource entitled “All They’ll Need to Know.”  You can, however, still obtain a copy of the “All They’ll Need to Know” booklet directly from Emerson Publications.  I have negotiated a discounted price on both the printed and electronic versions of the booklet which you can access by clicking on the Emerson Publications website link below:

http://emersonpublications.com/index.php?pr=ATNTK-Halbert&nosessionkill=1

I am making this valuable resource available as a service to my readers and I do not share in any part of the purchase price of either version of the booklet.  This discount is available for a limited time only, so I suggest that you take advantage of this offer as soon as possible. 

Wishing you profits,

 

Gary D. Halbert

IMPORTANT DISCLOSURES:  Halbert Wealth Management, Inc. (HWM), Sojourn Financial Strategies, LLC (Sojourn), and Purcell Advisory Services, LLC (Purcell) are Investment Advisors registered with the SEC and/or their respective states. Information in this report is taken from sources believed reliable but its accuracy cannot be guaranteed.  Any opinions stated are intended as general observations, not specific or personal investment advice.  Please consult a competent professional and the appropriate disclosure documents before making any investment decisions.  Investments mentioned involve risk, and not all investments mentioned herein are appropriate for all investors.  HWM receives compensation from the Advisors in exchange for introducing client accounts.  For more information on HWM or any other Advisor mentioned, please consult their respective Form ADV II, available at no charge upon request.  Any offer or solicitation can only be made by way of the Form ADV Part II.  Officers, employees, and affiliates of HWM may have investments managed by the Advisors discussed herein or others.

As benchmarks for comparison, the Standard & Poor's 500 Stock Index and the Barclays High Yield Credit Bond Index (which both include dividends) were used.  Both represent unmanaged, passive buy-and-hold approaches, and are designed to represent their specific market.  The volatility and investment characteristics of these indexes may differ materially (more or less) from that of this program, and these Indexes cannot be invested in directly.  The performance of the S & P 500 Stock Index and the Barclays High Yield Credit Bond Index is not meant to imply that investors should consider an investment in the Columbus High-Yield trading program as comparable to an investment in the “blue chip” stocks that comprise the S & P 500 Stock Index or the high yield investments that comprise the Barclays High Yield Credit Bond Index. Historical performance data from inception through December 2005 represents a tracking account managed by Steven D.  Landis and audited by MoniResearch, an independent corporation, Steve Shellans, President.  Performance from January 2006 forward is from an actual account in Purcell Advisory Services Columbus High-Yield Bond Program.  Since all accounts in the program are managed similarly, the results shown are representative of the majority of participants in the Columbus High-Yield Bond Program. 

Purcell utilizes research signals purchased from Sojourn, an unaffiliated investment advisor.  The signals are generated by the use of a proprietary model developed by Sojourn, with the objective of providing superior risk-adjusted returns using high-yield bond investments.  Assets in the program are allocated 100% to the appropriate high-yield mutual funds or 100% to the money market according to the purchased research signals.  Statistics for "Worst Drawdown" are calculated as of month-end. Drawdowns within a month may have been greater.  PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. 

When reviewing past performance records, it is important to note that different accounts, even though they are traded pursuant to the same strategy, can have varying results.  The reasons for this include: i) the period of time in which the accounts are active; ii) the timing of contributions and withdrawals; iii) the account size; iv) the minimum investment requirements and/or withdrawal restrictions; and v) the rate of brokerage commissions and transaction fees charged to an account. There can be no assurance that an account opened by any person will achieve performance returns similar to those provided herein for accounts traded pursuant to the Columbus High-Yield trading program.

In addition, you should be aware that (i) the Columbus High-Yield trading program is speculative and involves risk; (ii) the Columbus High-Yield trading program’s performance may be volatile; (iii) an investor could lose all or a substantial amount of his or her investment in the program; (iv) Purcell will have trading authority over an investor’s account and the use of a single advisor could mean lack of diversification and consequently higher risk; and (v) the Columbus High-Yield  trading  program’s fees and expenses (if any) will reduce an investor’s trading profits, or increase any trading losses.

Any investment in a mutual fund or money market fund carries the risk of loss.  Mutual funds and money market funds have their own expenses which are outlined in the fund's prospectus.  An account with any Advisor is not a bank account and is not guaranteed by FDIC or any other governmental agency.  Returns illustrated are net of the maximum annual management fee of 2.5%, custodial fees, underlying mutual fund management fees, and other fund expenses such as 12b-1 fees. Dividends and capital gains have been reinvested.  Management Fees are deducted quarterly, and are not accrued on a month-by-month basis. They do not include the effect of annual IRA fees or mutual fund sales charges, if applicable. Individual account results may vary based on each investor's unique situation.  No adjustment has been made for income tax liability. Performance for individual accounts may differ materially (more or less) from the results illustrated.  The results shown are for a limited time period and may not be representative of the results that would be achieved over a full market cycle or in different economic and market environments.

Copyright © 2009 Halbert Wealth Management, Inc. All Rights Reserved.


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Forecasts & Trends E-Letter is published by ProFutures, Inc. Gary D. Halbert is the president and CEO of ProFutures, Inc. and is the editor of this publication. Information contained herein is taken from sources believed to be reliable but cannot be guaranteed as to its accuracy. Opinions and recommendations herein generally reflect the judgement of Gary D. Halbert (or another named author) and may change at any time without written notice. Market opinions contained herein are intended as general observations and are not intended as specific investment advice. Readers are urged to check with their investment counselors before making any investment decisions. This electronic newsletter does not constitute an offer of sale of any securities. Gary D. Halbert, ProFutures, Inc., and its affiliated companies, its officers, directors and/or employees may or may not have investments in markets or programs mentioned herein. Past results are not necessarily indicative of future results. Reprinting for family or friends is allowed with proper credit. However, republishing (written or electronically) in its entirety or through the use of extensive quotes is prohibited without prior written consent.

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