Market Commentary - January 2016
“One man’s trash is another man’s treasure”.
- Idiom originated in Hector Urquhart’s 1860 Popular Tales of the West Highlands
And this year’s award for such ambivalence in the financial markets goes to… junk bonds. In this note we will delve into the origins of the market, an overview of the asset class, causes behind current market struggles and our strategies going forward.
Origins of Junk Bond Market
Standard & Poor’s started reporting on the financial strength of railroads back in 1860. Today they (Moody’s and Fitch) apply letter grades to companies to indicate financial strength. In the chart below, BBB represents the bottom of the “investment grade” for bonds. Dropping into BB or lower constitutes the “speculative” range; sometimes referred to as either “junk” or “high yield”, depending on one’s own trash/treasure prism. (1) Your bonds generally fall into the AA category or higher.
Prior to 1977, the junk bonds consisted primarily of “fallen angels”; bonds issued to investment grade companies that were subsequently downgraded to reflect deteriorating financial strength. However, four catalysts converged to create the actual market for junk bonds including:
- Fed policies caused volatility in the cost for borrowers
- Inflation, sparked by two oil shocks, punished bond holders
- Commercial and investment banks discovered that issuing junk bonds offered high profit margins
- Corporate raiders used junk bonds to finance hostile takeovers.
Junk Bonds as an Asset Class
In 1989, both Merrill Lynch and Lehman Brothers established indices to track junk bonds and the returns (highlighted in yellow) fit into an intuitive construct; better than high quality bonds, but not as good as stocks, as seen in the chart below. (2)
However, returns tell only half the story. Junk bonds have also delivered:
- Almost as much volatility (in blue) as large cap U.S. stocks since 1989.
- Nearly as many negative return years (5) as large cap U.S. stocks
- An abysmal “worst case” year (in green).
In baseball terms, this performance would be equivalent to a home-run hitter that frequently strikes out. That type of player might serve the needs of certain teams, but we deploy bonds specifically to buffer the volatility of your portfolio during turbulent equity markets. In 2008, when investors most needed bonds to behave like bonds, when they most needed the benefits of diversification, junk bonds came up woefully short going down 26.16%. They struck out.
In the chart below, we illustrate the performance of a 60% equity portfolio, changing only the bond component. (3)
The conclusions are pretty clear:
- Using a mix of corporate and government bonds added zero return compared to a pure Treasury portfolio. Not coincidentally, this conclusion lead to our correspondence last year explaining the rationale for changing the benchmark for your bonds to the Treasury Index.
- Using junk bonds instead of Treasuries, resulted in a higher return, but less than 1% per year.
- The cost of that extra return was a surge in volatility (blue) and a significantly worst case year (green; 50% worse in 2008).
In light of our clearly stated investment objectives of delivering index-like returns over a full market cycle with less volatility, a permanent commitment to junk bonds makes no sense. Consider the insurance parallel. Would you skimp on your fire insurance if your house burned once every four years? Then why save money on your “portfolio insurance” when the market tends to go down with equal frequency? (4)
This discovery resulted from our non-biased, research-driven perspective on investing. It has not been the path of least resistance to hold cash in your portfolios with a yield of zero, but we have remained disciplined and shared our rationale. In the past several years it would have been easier to “show you” the extra returns we were getting you with lower quality bonds, but we strongly believed that those apparent returns would prove to be an illusion over time.
Today’s Junk Bond Market
2015 was not a good year to own junk; it suffered its worst year since 2008 and the second worst year in its 26 year history, down 12%.
The poor performance stems from severe weakness in the energy sector. Oil has fallen from a 2014 peak of about $120 per barrel to about $37 at year’s end and the energy sector makes up approximately 15% of the current junk market. On December 10th, the already strained markets were rocked when Third Avenue Focused Credit (formerly run by respected manager Marty Whitman) announced the termination of redemptions, to facilitate an orderly liquidation of the portfolio and avoid a fire sale. Seasonally, these existing challenges collided with tax loss selling, exacerbating the rout.
Junk bonds offer a current yield of 8.2%. However, actual returns will be diminished by the estimated 4.0% default rate. (5) Unlike Treasury bonds, there is no guarantee that both interest and principal will be repaid. Furthermore, the ordinary income generated from junk results in the least efficient tax treatment. (6)
In addition to the absolute returns, most junk interpretations include the yield relative to Treasuries, also known as the “spread”. Today junk yields approximately 7.0% above Treasuries. The first graph below shows the widening of that spread in 2015, driven by falling prices for junk bonds and indicative of diminished risk appetites.
However, the graph below puts that into historical perspective and suggests the yields, though elevated, are not yet compelling on either an absolute or relative basis. (7)
Collapsing junk markets inflicted pain on many unsuspecting investors naively scurrying for yield outside their comfort zone; driven by Fed orchestrated, paltry interest rates. Years of drought conditions also moved animals, used to getting sustenance in a familiar territory, to more populated areas in their quest for food and water, frequently with unfavorable results.
This crawl further out on the limb for yield certainly hasn’t been limited to high yield/junk bonds. Utility stocks, once the haven for “widows and orphans”, now trade at historically high valuations. Thirsty for big dividends, many yield-seeking investors were attracted to integrated oil stocks in 2014, but those who were seduced by the siren’s call were ultimately dismayed to discover that the stock values move in tandem with oil prices. Today, while avoiding any sensationalist market calls, we see a similar pricing pattern in preferred stocks and real estate investment trusts. (8) All of these markets remain vulnerable to the normalization (rising) of interest rates.
To reiterate, we have no interest in a long-term or strategic allocation to junk bonds. They do not offer attractive risk-adjusted returns over time and work against the easily attainable benefits of diversification. However, we do see the possibility for a temporary, or “tactical” position, if and when the markets unleash a sufficient amount of damage. In baseball vernacular, we see junk as a potential “fat pitch”, where the upside would seem much greater compared to the downside risk. Such pitches don’t appear often – last seen with both stocks and California bonds in 2009.
Both cash and high quality bonds offer uninspiring yields. Stocks trade at the upper end of a reasonable multiple range and will require earnings growth to deliver decent total returns, especially in light of currency headwinds and unending geopolitical tension. You can rest assured that in 2016, we will be carefully monitoring the market, including junk bonds, searching for some treasure that has been mistaken for trash. Should a fat pitch arrive, we will be prepared to swing
1. Chart published by Standard and Poor’s.
2. Intermediate Bonds are represented by BarCap Intermediate Govt/Corp Index; Stocks by S & P 500; Junk bonds by BarCap High Yield Index. Raw data from Chase Data. All calculations by WCF.
3. These three portfolios are identical with regards to cash, S & P 500, Russell 2000 and EAFE exposure. The only difference in the three is the bond component where it moves from the BarCap Treasury Bonds Index to the BarCap Intermediate Govt/Corp Index to the BarCap High Yield Index.
4. S & P 500 has been negative in 10 of the past 43 years. The Russell 2000 (small cap stocks) has been negative in 13 of the past 43 years. MS-EAFE (Foreign stocks) has been negative in 12 of the past 43 years.
5. Bloomberg; December 18, 2015 citing Moody’s; Fitch, S & P. Default rates are quoted net of anticipated principal recovery.
6. Interest on bonds is subject to ordinary income tax rates in contrast to both qualified dividends and capital gains that are subject to more favorable rates.
7. St. Louis Federal Reserve Bank.
8. The current yield on the Vanguard REIT ETF is 3.94%