I’m introducing a new asset class this week.

music selection:  “Mandatory Suicide” — Slayer

weigh-in:  216.0 (0.2) #loser

My quest for risk adjust yield never ends.  Today, I’m going to talk about the opportunity in buying deeply discounted high yield bonds.  That might make some of you nervous so I’m going to do the basic arithmetic to show the market prices these bonds inefficiently.

A word about the people who hold bonds – Mostly bonds are held by institutional investors.  They usually have a covenant that requires them to hold only “investment grade” bonds.  Sometimes they can hold a small mix of “high yield” bonds in their portfolio but it is usually highly restricted.  This creates a real problem when a bond gets downgraded.  The funds can often no longer hold them legally and are forced to sell at steep losses.  This is our opportunity.

Bonds are clearly different than stocks.  There is a binary component to returns.  They pay, or they default.  A bond can’t sort of default any more than you can’t become kind of pregnant.  Default triggers a bunch of legal machinery that ensure the company is restructured or liquidated in a manner that pays bond holders *first* (equity holders are dead last and are usually completely wiped out in a bankruptcy.)  It isn’t all roses.  Bankruptcy, on average, sees bond holders compensated about forty cents on the dollar.  So I’m going to say this twice, if you choose to invest in high yield bonds you must stay diversified.  Did I mention the importance of diversifying into a basket of bonds?

We are interested in two categories of high yield bonds, those rated in the “B” range and those rated in the “C” range.  Bonds rated “D” are already in default and are toxic.  There is money to be made in the “D” space as well but you really need a team of bankruptcy lawyers sort the wheat from the chaff.  Don’t go there!  The historical default rate for “B” rated high yield bonds is 4.28%.  The historical default rate for “C” rated high yield bonds is 26.85%.  If the price is right, you can make really strong returns in both categories.  The math:

default raterecovery rateweighted average
4.28%40.00%1.71%
95.72%100.00%95.72%
“B” Rated Expected Value97.43%
26.85%40.00%10.74%
73.15%100.00%73.15%
“C” Rated Expected Value83.89%

So for “B” rated issues, we expect to earn capital gains when the bond is purchased for less than 97 cents on the dollar.  For “C” rated issues, we expect to on average earn capital gains when the bond is purchases for less than 83 cents on the dollar.  Because of forced selling, these hurdles can very easily be cleared.  There are many “B” rated bonds trading for 60 cents on the dollar and many “C” rated bonds selling below 20 cents on the dollar.

There are two components of the yield.  The first is the coupon.  The coupon is a stated interest rate that the bonds pays out twice a year assuming 1,000 dollars of principal.  Your yield is proportionally higher than the stated rate by the amount of the discount you were able to purchase the bond for.  I have one bond in my portfolio that is paying 53% of my cost basis per year.   The second is the capital gains.  At maturity, the bond is supposed to pay 1,000 dollars in return of capital.  If you bought the bond for less than “100”, you will realize capital gains.  You will need to divide by the multiyear holding period to get the annualized return there.  “C” rated bonds that  you buy for “20” have a 73% chance of returning 5 times your investment, for example.

I am going to target bonds with a maturity 5 years or less.  And I am going to hold roughly an equal mix of “B” and “C” rated bonds.  And I’m going to be “stink bidding” them all.  The lack of liquidity in this sector of this market means patience can pay off real deals as people with forced hands must go searching for bids at any price.

If you want to play the home game, I highly recommend Interactive Brokers.  All you need is the CUSIP number for the bond (available from: http://finra-markets.morningstar.com/BondCenter/) and you can order the bond with a limit order directly from the web interface.  Most other brokers will require you to pick up the phone and talk to the Bond Desk.  Most brokers will have a minimum purchase on bonds, other 5 to 10 bonds.  The Interactive Broker’s minimum is usually only 2.  IB commissions are usually 1 dollar per bond as well.  They can charge up to 6 dollars per bond in their commission structure but I have never been charged anything more than a single bone.

I’ve already mentioned this twice but I’m coming back to a third time.  If you do this, you have to stay widely diversified.  If you buy just one bond and it defaults, you are probably going to lose a good deal of money.  If you build up to 20 or more positions, you mathematically stand a very good chance of outpacing the S&P 500, earning good cash yield on the way.

I’ll introduce the bonds I currently hold and those I have Good Till Canceled orders open on Wednesday (and add to open positions page as appropriate.)

Devour your prey raptors!

 

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Introducing Discounted High Yield Bonds

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2 thoughts on “Introducing Discounted High Yield Bonds

  • December 8, 2015 at 8:50 pm
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    Hi – thanks for explaining this in a way that is easy to understand. I’ll have a look what choices I have here in Australia, but I wouldn’t be surprised if they were a lot more limited than what you have access to in the US. Two questions:

    1) Where did you get those default rates from? Just want to know what they are for higher-rated bonds (for my own peace of mind).

    2) What are your thoughts on funds that adopt this strategy themselves? I haven’t checked it out but I know there are lots of high yield bond funds. Is the major difference that they are unable to take advantage of the inefficient pricing?

    Reply
    • December 9, 2015 at 12:27 am
      Permalink

      Justin,

      In most markets the bond market is much larger than the equities market. There are probably lots of bonds available in Oz. Whether or not you are allowed to buy them retail is a regulatory matter I know nothing of.

      1) The default rates are public domain information that comes from the ratings agencies. Investment grade bonds have an extremely low default rate, about a tenth of a percent. They do not ordinarily trade for meaningful discounts. You can read (A LOT!) about bonds in layman’s terms here: http://bonds.about.com/

      2) I don’t know of any good closed end funds that use this strategy. Some hedge funds play in this space but they are not available to us small fish with less than literal millions to put on deposit. The ETFs and mutual funds that do this have to provide ‘7 day liquidity’ by law and are forced to sell at steep losses as the credit cycle turns to meet redemptions. They are great investments when things are rosy (high yield) but are going to get killed shortly. Defaults are already rising and bond investors will panic soon (they always do). That is the opportunity for a retail investor. “B” range “junk” selling below 90 cents is, on average, a great bargain. I just make sure to be widely diversified. I target below 70 cents on the dollar for “C” range junk bonds to keep from ending up with net capital losses. Coupon yield is just tasty gravy.

      Reply

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