On Thursday my colleague Greg Jones and I listened to a conference call sponsored by global mutual fund manager BlackRock. They manage more than $1.25 trillion in assets in 60 countries. The conference call centered on high-yield fixed income securities. If you think common stock investors took a shellacking in the market, wait until you hear what happened to high-yield bond investors since September.
Mitchell Garfin, a BlackRock director and fixed income portfolio manager, started the presentation with a blow-by-blow account of how bond investors were treated like crash dummies hurled into a concrete wall at 65 miles per hour. Yes, it was that bad.
As a worldwide investor, BlackRock has incredible research and intelligence-gathering capability so they know their markets. Their mantra is risk management. Nonetheless, its High Yield Bond Fund A (BHYAX $4.83) -- like its high yield bond fund peers -- lost more than 20 percent of its principal value since the onslaught that began a few months ago.
How and why this happened requires a bit of background. First, in the parlance of bond managers, high yield bonds are referred to as "junk" bonds because their ratings are below investment grade. Standard & Poor's bond rating system starts at AAA (highest), followed by AA, A, BBB, BB, and down to C. Bonds rated BB and lower are considered below investment grade and hence, "junk" because they are deemed "predominately speculative." Moody's Investors Service uses a slightly different system, (Aaa, Aa, A, Baa, etc.) with junk designated as Baa and lower.
When the economy enters a recession, bond investors tend to sell lower grade bonds and buy higher-grade corporate bonds or U.S. Treasuries to reduce the chances of owning bonds that default. This so-called "flight to quality" response is actually measured by what traders call the "yield spread," the difference between what U.S. Treasury obligations yield and what junk bonds yield. Since bond values are inversely related to yield, it's easy to see how yields rise when bonds fall in price. For example, if you bought a corporate bond for $1,000 (let's not worry about maturity for the purpose of this example) that pays $50 per year in interest, the yield would be 5 percent ($50 divided by $1,000). But if you decided to sell the bond at the market, and $700 was the only bid, the bond at that price would yield 7.1 percent ($50 divided by $700) to the new owner. You, on the other hand, just lost $300 on your original $1,000 investment.
If U.S. Treasury obligations are yielding 2 percent, the yield spread between the bond you just sold and the Treasury would be 5.1 percent (7.1 percent less 2 percent). More jargon: bond traders use "basis points" to measure this spread with 1 percentage point equaling 100 basis points. So bond traders would say the yield spread was 510 basis points.
Take a wild guess at what the yield spread was during the 2000-02 bear market? According to Garfin, the peak was 1100 basis points (11 percent) between junk bonds and U.S. Treasuries. What is it today? Try almost 1900 basis points, an all-time high.
What caused this sudden collapse? Again, the trail leads directly to our friendly hedge fund managers. Garfin's bond market operatives tell him that hedge fund managers used leverage -- they borrowed 4 to 5 times their equity investments -- to build their junk bond portfolios. When their lending banks called in their loans they were forced to sell. In fact, they HAD to sell regardless of market conditions. Potential buyers saw this unfold and they just lowered their bids accordingly. Others, fearing defaults, just went on a buyers strike. The resulting carnage produced the highest yield spreads on record.
So are high yield bond investors overreacting to potential defaults? According to John Lonski, chief economist at Moody's Investors Service, about 5 percent of all junk bonds default in a typical economic cycle: obviously more during bad times and fewer during good times. The current default rate is just 1.1 percent, but Lonski expects defaults will exceed the 5 percent average in 2009. The managers at BlackRock, however, are anticipating defaults to hit 8-12 percent in 2009.
With that background, let's get back to Garfin's presentation. Using simple present value math, Garfin calculates that today's yield spreads discount the most dire economic possibilities. His figures that if an investor put $1,000 into a junk bond fund today and if that fund suffered 20 percent defaults -- each year -- for five straight years, and if only 25 percent of the principal value of the defaulted bonds are recovered through bankruptcy court, the fund value would still be worth $1,000 at the end of those five years.
Five years of annual 20 percent defaults? That's Armageddon. If that doesn't happen, junk bond funds could produce double-digit returns when the economy recovers. For those who want to assume some risk, junk bond funds now look mighty interesting.
Note: Forward Investment Advisors, Inc., has been acquiring various high yield bond funds for its clients and principals.