The Aleph Blog » Blog Archive » On Junk Bonds

On Junk Bonds

If someone were to ask me my opinion on Junk Bonds at present, fool that he would be to ask me because I know real experts elsewhere, I would say this: They are good for a speculative trade, but dumb money has arrived.  Be ready to sell when the momentum fails.

High yield ETFs sell at decent premiums which leads to the creation of more units.  High yield closed-end funds — 73% trade at a premium.  You could issue a new high yield CEF, and come out at a lower premium than the current average.  I think I smell smoke.

Hmm….  If I owned junk bonds I would hold, and wait for momentum failure.  Buying now seems risky to me.  Most of the risk stems from global conditions.  We don’t know what will happen in the Eurozone. The rest of the risk stems from speculation.

I am a fan of junk bonds when nobody likes them, but there are too many fans now, and for bad reasons, most of which boil down to “I am old and I need income.  The fed has eliminated good choices for income, but I need income anyway, so get me yield.”

I had a conversation with a friend of mine in her upper 70s today where she asked “why are you suggesting I sell my funds that provide the most income?”  I said that I did not trust junk bonds at present and would look to lighten up, besides, the fund she owned has underperformed over the last 10 years.  If she really wanted income from junk bonds, I would look for a new fund for her.  So I am looking for a new HY fund, with an arm twisted behind my back.  It’s not the right idea, but she won’t listen.  (She’s not paying me.  I help my friends as best I can.)

The illusion of yield drives many older investors; they need income, and the delusional Fed thinks that low yields will yield prosperity.  It may make some people take more risk, but it will not yield prosperity.  There will be a lot of impoverished old people at the end of this, and they will be angry — at themselves, their advisors,  and the powers that be.


This is not to say say that junk spreads are low; they are moderate to high at present.  But the spread relationship is manipulated by the Fed at present, making spreads seem high.  No market is truly free, but the Treasury market is affected by the Fed to a high degree.  The high quality bond market follows Treasuries closely.  Junk bonds don’t.  Junk bonds follow a hybrid of what Treasuries and common stocks are doing.  With stocks doing well, junk bonds run as well.

But we are still in an environment where more things can go wrong than right.  Until the US government figures out how to finance itself, we are in dangerous territory.  Given present political conditions, I don’t see how that works out; everything looks like a stalemate at present.

So be wary, and don’t overcommit to risk assets.  I would be neutral on risk assets at presemt, but ready to be bearish if there are problems in Europe or China.



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8 Responses to On Junk Bonds

  1. kapil says:

    Hi David, Why not recommend an ETF to your friend. HYG has reasonable fees, liquidity and options for potential hedging.

  2. izimbra says:

    A strategy that makes sense to me for think about fixed income funds is too look for instruments that potentially have some negative correlation to each other going forward. With that in mind, I suggest the following categories:

    Cat 1) Higher yielding funds that tend to be positively correlated with the economy and the U.S. stock markets – one could pick a junk bond fund here, or something a little more conservative. In the latter case, I currently like the CEF EVV

    Cat 2) Funds that tend to correlated to treasuries and negatively correlated to the economy and the stock market – Here I go for closed end muni funds that boost yields with leverage and offer tax advantages. There is a state specific factor, and a choice of duration focus, but some national possibilities include NPT, MUI, NQS, NZF.

    Cat 3) Fixed income funds that are denominated in commodity currencies, so they tend to be positively correlated to the world economy and offer some protection against inflation – Here I pick the ETFs ELD, and AUNZ.

    Cat 4) Fixed income funds that have low correlation to everything – CIU seems to achieve this.

    The stuff in Cat 1) tends to offer the highest yield, the most risk, and the most correlation to stocks. Instead of holding junk bond funds at the present, it seems to me it would make more sense for the older investor to put a portion of their funds in a stock index fund reasoning that if high yield funds are doing well then stocks are doing well too and the investor can simply sell some of their stock to take as income and restore balance to their portfolio, while if stocks are not doing well, then high yield funds are also down, so the investor will be glad they spread their allocation among the other categories listed (particularly the muni funds).

  3. Pacioli says:

    Let’s try to flesh out some glaring inconsistencies:

    “The fed has eliminated good choices for income…”

    “the delusional Fed thinks that low yields will yield prosperity…”

    Assertions like these make the extremely controversial assumption that interest rates would be any different without the Fed’s intervention. Aside from ultra-short maturities (say, 2 yrs and below), the Fed has very little ultimate control over longer-term rates. For surely someone like you must know that Treasury holders can always buy and sell Treasuries (i.e. drive the price movements) with or without Fed intervention.

    Again, to insinuate that the Fed is responsible for low rates across the entire curve is disingenuous, IMO. This would imply that the Fed’s policy has actually had some impact. Which you have vehemently argued against in the past. (Incidentally, I mostly agree that QE largely has no effect – one way or the other.)

    No, interest rates are low across the curve because of massive deflation across the domestic economy’s private sector. Plain and simply. In other words, it is a market-driven phenomenon. And it is a large enough force that it will completely manifest itself eventually, regardless of the Fed’s (or any other intervening force) level involvement.

    And now to address this dangerously erroneous (though unfortunately still widespread, even among ‘experts’) notion:

    “Until the US government figures out how to finance itself…”

    Surely, someone in your position must realize that the US gov’t does not ‘finance itself’ via debt. That is simply an erroneous characterization of the mechanics. You understand this, right? If so, it seems dangerous to propagate this notion to readers who (likely) may not understand.

    In conclusion, I want to reiterate I am a huge fan of the blog. Mainly because even though I do not often agree, the posts usually seem to at least raise the right questions for productive debate.

  4. [...] The “dumb money” is in junk bonds.  (Aleph Blog) [...]

  5. tombrakke says:

    Here’s a recent “pix” from last week, including a link to my “junk for grandma” posting from last spring:

    Whenever this trade comes unwound, it will be violent, as it has been at other times in the past. The risk far exceeds the expectations of risk.

  6. [...] David Merkel: The rush into high yield ETFs (JNK, HYG) is not going to end well.  (Aleph Blog) [...]

  7. [...] Value investing ( One, two, three, four, five, six, seven) [...]

  8. [...] The Aleph Blog » Blog Archive » On Junk Bonds [...]


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