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From time to time we comment on high yield bonds (sometimes called “junk bonds”) because we think they may be of interest to turnaround investors for several reasons. While they are called bonds, many high yield issues have return--and risks--characteristics closer to stocks than to other fixed income instruments. Also, many companies that issue high yield debt are in the process of turning around, or at least trying to. And some high yield issuers don’t make it, file for Chapter 11 and eventually provide interesting distressed bond or post-bankruptcy stock opportunities.
While we generally like high yield bonds as a place to invest--the BofA/Merrill Lynch High Yield Index has a solid 10-year annualized total return of 7.8%--high yield returns tend to be somewhat cyclical. And, to quote an experienced high yield investor we know, the cycles “tend to end badly.” The two graphs in this article suggest that we may be coming to a bumpy end to the current good times in the high yield market.
The graph below tracks high yield “spreads” over time. The high yield spread is a measure of the return premium you get for investing in a riskier asset like high yield bonds compared to a safer asset such as U.S. Treasury bonds. When the spread gets narrow (i.e. low), you aren’t getting paid much for the additional risk you are taking on.
As the graph above shows, the spread is currently at its lowest level since 2007. The graph also shows that periods of narrow spreads are often followed by significant spread widening, which means that the prices of high yield bonds are dropping.
This second graph that gives us pause shows high yield and bankruptcy cycles going back to the late 1980s. As the graph above shows, each time we’ve had lot of high yield bond issuance, it has been followed by a surge in defaults and bankruptcies. You can also see from the graph that the current high yield boom has gone on longer--with the result that more high yield bonds have been issued, by far--than in any of the previous cycles.
These two graphs suggest that this is not the time to go into high yield bonds. We would rather wait for the defaults and bankruptcies to happen, and then look to profit from the distressed bonds.
The February issue of The Turnaround Letter also details six value investment opportunities with acquisition friendly traits and an oil & gas small cap stock pick that checks many key turnaround boxes. Subscribe now for immediate access to more of George Putnam’s latest market advice and turnaround stock picks.