Everyone knows what junk is: discarded items of little use or value. Yet from time to time some fabulous treasure gets pulled from a trash bin or purchased at a second-hand store for a few bucks. We see these items on the long running television series, the Antiques Roadshow.
This reminds us of our work with a different kind of junk. The polite euphemism for bonds issued by relatively weak companies is ‘high yield.’ Just between us, let’s call them by a more accurate term: junk bonds. From time to time, at rare intervals over the past seventeen years, we have found something we believed to be investable hiding in the junk pile.
A perfect storm may be brewing in the junk bond world. Federal Reserve Bank statistics indicate that the size of the junk bond market has doubled in the past decade, to nearly $2 trillion outstanding. Adding in another category, junk-rated floating rate bonds, puts another $1 trillion on the pile.
1. When financial conditions tighten and corporate results weaken (as they will sooner or later), higher quality bonds may also be marked down to the junk category.
2. The capacity of dealers and other market makers to deal with waves of selling has been dramatically reduced by financial regulations1. Large banks were once players, but trading for their own accounts has been curtailed. Formerly, they stepped in at market extremes to support prices. In the next crunch, they are not likely to be there.
3. We believe some fraction of junk may be held by people who may not realize they own it—hidden in other financial products sold to investors.
4. We have characterized the movement into the apparent safety of bonds over the past decade as a stampede, based on the size of cash flows and the ridiculously low interest rates. (That’s just our opinion.) If that money stampedes out…prices may plunge to lower levels.
Clients, we strive to deal with reality as we see it. The next downturn in the economy is out there somewhere. Our holdings will continue to fluctuate in value, and we will have a down year at some point. But we are excited about the opportunities that may arise in the years ahead.
Junk bonds may not be appropriate investments for all clients. If you would like to talk about this or have something else on your agenda, please email us or call.
Notes and References
1Regulatory Changes Impacting High Yield Liquidity, Pensions & Investments. http://www.pionline.com/article/20151228/PRINT/151229939/regulatory-changes-impacting-high-yield-liquidity. Accessed June 11, 2018.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results.
The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.
Floating rate bank loans are loans issues by below investment grade companies for short term funding purposes with higher yield than short term debt and involve risk.
High yield/junk bonds (grade BB or below) are not investment grade securities, and are subject to higher interest rate, credit, and liquidity risks than those graded BBB and above. They generally should be part of a diversified portfolio for sophisticated investors.