U.S.

Junk Bombs!

U.S. junk bonds are time bomb with a long fuse

NEW YORK, Dec 29 (Reuters Breaking Views) - U.S. junk bonds are a time bomb with a long fuse. Low default rates, a lack of alternatives and foreign demand will support high-yield bonds in 2018. Yet with spreads near record lows, covenants weak and leverage rising, the seeds of a bear market are plentiful. 

Demand for yield from pension funds, endowments and other investors has driven the spread - or premium over U.S. government bonds - near levels not seen since the pre-crisis boom. It's unlikely to rise anytime soon. Despite a sharp spike from the energy sector's woes two years ago, the default rate on high-yield bonds should decline to 2 percent by the end of 2018, the lowest since 2013, Fitch forecasts. 

The yield premium on high-yield bonds relative to comparable U.S. Treasuries hit 3.61 percentage points at the end of November, 

down a full point from a year earlier and near the post-crisis low of 3.35 percent set in June 2014, according to Bank of America Merrill Lynch. The spread has not traded consistently below that level since the eve of the financial crisis in 2006 and the first half of 2007.

 

DYI:

There’s a time to hold, fold, or cash in your chips.  If you own high yield paper – A.K.A. junk bonds – the time to sell – cash in your chips – over the past two years.  The spread is significantly below the average 579 basis points – or 5.79%.  Today the spread is only 3.61% very little bang despite the high risk for your dollars.  The best time to buy and in my humble opinion, the only time to purchase junk bonds are during an economic downturn when spreads break the 10 percent threshold.

Benjamin Graham

“It is our argument that a sufficiently low price can turn a security of mediocre quality into a sound investment opportunity — provided that the buyer is informed and experienced and he practices adequate diversification. For, if the price is low enough to create a substantial margin of safety, the security thereby meets our criterion of investment.”

When junk bonds drop in price significantly with spreads greater than 10% they move from speculation to an investment with a high degree of safety.  Of course this goes against human nature of selling when everything looks safe and buying during the depths of despair.  Until despair arrives DYI will ignore – but not forgotten – high yield paper.

 DYI