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Published:
March 7, 2009
It's
an age-old investing trade-off.
Stocks can create untold wealth, but they can also end up
worthless if things go horribly wrong. By contrast, bonds are
seen as more secure, but that stability usually means settling
for fixed income payments and not much else in the way of upside
potential.
What if bonds could deliver dependable income and sizeable
capital gains?
That's not just a hypothetical scenario. As we've seen in recent
months, a number of relatively tame bond funds are posting wild
stock-like gains -- truly the best of both worlds.
And there's more to come. In fact, it's not an exaggeration to
say that bond investors could be looking at an historic buying
opportunity. However, over the past few weeks, hundreds
of billions have been flowing into higher-yielding bond funds.
That's a sure indication that many investors are no longer
willing to accept miniscule rates near 0% on their money -- not
when they can get 7% or more from corporate bonds and even more
from "junk" bonds.
One of my favorite high-yield
funds boasts a hand-picked portfolio that's on pace to crush its peer group
for the third straight year. (I just added this fund to the
"High-Income" portfolio of my
ETF Authority newsletter on March 2nd.) The portfolio
of this fund offers exposure to
nearly 300 bonds, most of which are clustered just a notch or
two below investment grade. These holdings might be classified
as "junk," but that term is both unfair and misleading.
Believe it or not, more than 50% of all corporate debt falls in
this category -- so we're not talking about a small percentage
of highly speculative firms. In this case, shareholders will
have a stake in bonds issued by well-known companies such as
Expedia, DirecTv, Neiman Marcus, and Sprint.
This fund has built a distinguished track record over the years, and
its managers have earned their paycheck by bringing added value
to the table. Last year, they plowed extra cash into the capital
goods and utilities sectors (two of the market's better
performers), while underweighting laggards like consumer
cyclicals. As a result, the portfolio only dipped -29.7% --
painful, but still much better than the -41.5% plunge for the
average high-yield bond fund.
I probably don't need to remind you that the deteriorating
economy is casting a pall over earnings and bad debt is on the
rise. In fact, Moody's is forecasting that high-yield default
rates could hit 15% in 2009, about 4 times what we might see in
a normal year. However, as was the case in the investment-grade
sector, those expectations are already priced in and current
valuations imply a disaster of epic proportion.
Simple math reveals that today's yield spreads will still mean
profits for high-yield investors even under the most calamitous
of circumstances.
At today's whopping interest rates, default rates could hit 20%
for the next 5 years in a row (assuming 25% of the principal of
any bad debt is recovered in court), and a $1,000 investment
would still break even and be worth $1,000 five years from now.
And the chances of things getting
that bad are slim. We're already over a year into the
recession, and default rates currently stand at just 5%. That
rate will go higher, but will likely fall short of the 55 or so
failures per quarter needed to break the old record and touch
15% -- let alone 20%.
Even then, I'm betting that the managers of this high-yield fund can sniff out and
avoid the more troubled issues.
Are things bleak? Absolutely. But with great challenge comes
even greater opportunity, and the fund's steady monthly
distributions now provide a payout of +16%. Throw in additional
capital gains as confidence returns and prices moderate, and you
have the recipe for a record-breaking year.
Is a lofty 16% yield enough of an incentive? That's a question
only you can answer.
For my money, the numbers appear so out of whack that default
rates could spike to record highs and junk bonds would still be
profitable. The only thing we need to spark an explosive rally
is a hungrier appetite for risk -- and we could be seeing that
already. Not only are fund inflows on the rise, but junk-rated
companies have raised $5.6 billion through new offerings so far
in 2009, more than the second half of 2008 combined.
Good Investing,
-- Nathan Slaughter
Editor
The ETF Authority
P.S. If you'd like to learn the name of
the high-yield bond fund I mentioned above, I invite you to
join me at The ETF Authority. I just profiled this
fund in detail in the March issue, which is available
immediately to new subscribers.
Learn more about The ETF Authority here.
P.P.S. The $3.6 trillion government stimulus spells windfall
profits for informed investors who act now. Some sectors
will be flooded with so much new cash shares could climb 4
and 5 times higher.
I explain all this in detail right here.
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