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 rate||recovery rate||weighted average|
|“B” Rated Expected Value||97.43%|
|“C” Rated Expected Value||83.89%|
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!