Saturday, March 7, 2009

Volume 3, Issue #17

Also in Today's Issue...

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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