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Time to put some junk in the trunk?
Old 07-31-2008, 08:58 AM   #1
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Time to put some junk in the trunk?

By which I mean, is it a good time to buy some below investment grade bonds? Vanguard's high-yield bond fund (which is less junky than most) is yielding 9.15% (VWEHX). Their intermediate-term treasury fund (VFITX) is yielding 3.40%. Duration for both is about 5 years. If you look at the 1 year performance, the treasury fund is up 12.65% whereas the junk fund is down 2.26%. Can you say, flight to quality?

Given the spread over treasuries of 575 basis points, junk seems like a good value at this point (obviously there's some risk). What do you think?
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Old 07-31-2008, 09:08 AM   #2
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I hate to be accused of chasing yield ( do I really?) but seriously, how much risk would their be with Vanguards high yield fund? My one thought is the capital appreciation is negative since inception, is that an opportunity for reversion to the mean, or will it continue to slowly decline as these junk companies go under?
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Old 07-31-2008, 09:18 AM   #3
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Check out the bottom graph of the 5 year BB corporate bond spread over treasuries.
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File Type: gif sg2008073136804.gif (45.9 KB, 25 views)
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Old 07-31-2008, 10:26 AM   #4
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It does seem that since junk has been taken out and shot, the risk is already in the securities. If the spreads are high historically (is that what the chart above shows?) then this would be a good time to invest in junk. Not only for the yield, but also for potential capital gain when the spreads narrow again.

Audrey

P.S. How much risk could there be with Vanguards high yield fund? - just because it's Vanguard doesn't mean it is low risk. Junk is by definition high risk. So you should only buy it when the category has already been punished.
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Old 07-31-2008, 11:43 AM   #5
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I takes my risk in my stock funds. Nothing but govt backed bonds in my bond allocation - which has done very well and as expected over the last year...

DD
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Old 07-31-2008, 11:57 AM   #6
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Originally Posted by laurencewill View Post
I hate to be accused of chasing yield ( do I really?) but seriously, how much risk would their be with Vanguards high yield fund? My one thought is the capital appreciation is negative since inception, is that an opportunity for reversion to the mean, or will it continue to slowly decline as these junk companies go under?
There will definitely be reversion to the mean at some time.. But it could be from a considerably wider spread than the current one.

RTM investing is usually successful, but frequently also painful. Just look back at all the posts from varius times about what is "on sale".

Ha
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Old 07-31-2008, 02:37 PM   #7
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Originally Posted by audreyh1 View Post

P.S. How much risk could there be with Vanguards high yield fund? - just because it's Vanguard doesn't mean it is low risk. Junk is by definition high risk. So you should only buy it when the category has already been punished.

Vanguard stretches the definition of "Junk" a little bit. Average credit is much higher than most true junk funds.
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Old 07-31-2008, 08:28 PM   #8
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No comments from Brewer? I thought this was right up his alley.
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Old 07-31-2008, 09:44 PM   #9
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Well stocks are getting cheaper, especially value stocks, as junk is getting cheaper. So, which one? IMO, HY bonds don't make a portfolio more efficient, or for the lay person, add anything to an existing portfolio of stocks and bonds.

btw - There was a good article in the Spring 2008 Journal of Fixed Income by William Reichenstein that breaks down the different riskiness [read: stock and bond components] of 60 HY bond funds, including those from Vanguard and Fidelity.

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Old 07-31-2008, 10:52 PM   #10
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While I own some junk bonds, I've come to the conclusion that they largely share the risk characteristics of equities without the upside potential. HY bonds also often contain call provisions and other features that can be investor unfriendly (David Swenson does a good job going through the misalignment of interests b/w HY issuers and investors in Unconventional Success). I'm going to trade out of my HY funds when (if) spreads narrow in the future.
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Old 07-31-2008, 11:25 PM   #11
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I've come to the conclusion that they largely share the risk characteristics of equities without the upside potential.
BINGO!

HY bond funds have return/risk characteristics much more similar to equities than bonds. When you think about the reasons for holding bonds in a portfolio, it is to reduce risk (dampen volatility). HY will not do that for you - when equities are tanking, HY NAVs will typically decline in concert. If you think about the low-quality debt these companies are issuing that makes sense.

Also as others have mentioned, HY upside is capped. If a company's financial picture improves it will call in its high-rate bonds and reissue at a lower rate. Far better IMO to simply own equities and to hold bonds for defense, not offense.
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Old 07-31-2008, 11:44 PM   #12
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While I own some junk bonds, I've come to the conclusion that they largely share the risk characteristics of equities without the upside potential.
They are definitely like holding equities and certainly do a poor job of having a low correlation with equities. Just look at the behavior in 2002 and it's quite obvious that both equities and junk bonds can go down big time together.

However, as long as you are not relying on junk bonds for portfolio diversification against equities and you want something that throws off a lot of income (for some reason), this is probably the right environment to buy them.

Audrey
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Old 08-01-2008, 12:02 AM   #13
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True - I suppose it depends on whether you follow the dividend or total return strategy. Since I am in the latter, I see no purpose for HY.
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Old 08-01-2008, 05:44 AM   #14
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They are definitely like holding equities and certainly do a poor job of having a low correlation with equities. Just look at the behavior in 2002 and it's quite obvious that both equities and junk bonds can go down big time together.
HY bonds are more like holding a combo of stocks and high quality corp bonds. The Vanguard fund is more corp bond like [like 30% stocks 70% corps], while the funds from Fidelity is probably more stock like [50-60% stocks and 40-50% corp bonds].

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However, as long as you are not relying on junk bonds for portfolio diversification against equities and you want something that throws off a lot of income (for some reason), this is probably the right environment to buy them.
You basically getting some equity returns in the form of bond coupons, so if you hold them in a taxable account you have some really tax inefficient returns from equity. Also, don't forget to factor in the likely defaults, which has been 1.5-2% per year in the Vanguard fund.

- Alec
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Old 08-01-2008, 05:54 AM   #15
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Originally Posted by innova View Post
BINGO!

HY bond funds have return/risk characteristics much more similar to equities than bonds. When you think about the reasons for holding bonds in a portfolio, it is to reduce risk (dampen volatility). HY will not do that for you - when equities are tanking, HY NAVs will typically decline in concert. If you think about the low-quality debt these companies are issuing that makes sense.

Also as others have mentioned, HY upside is capped. If a company's financial picture improves it will call in its high-rate bonds and reissue at a lower rate. Far better IMO to simply own equities and to hold bonds for defense, not offense.

All of this is true and a reasonable argument not to buy HY bonds.

But with 10 year T-Bonds yielding 4% and TIPs at 0-1% with inflation running much higher than 4%, I'm not sure that not buying HY bonds means you should be buying government securities. Buying government bonds today is like playing an entire football game with a prevent defense, you know the other team is going to score a lot the only question is how badly you lose. At least with HY bonds you have a chance of making a postive real return. A spike in interest rates will kill the nominal returns on government bonds, but may not hurt HY too much if credit spreads narrow.

It seems to me in the bond market all options stink, although Muni's may only have an unpleasant odor.
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Old 08-01-2008, 09:14 AM   #16
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Doesn't one of the gurus of portfolio theory claim that you should manage your risk by balancing Equities (choose your risk level) with very safe fixed income? IIRC, the idea is that 'medium' risk investments don't provide enough return to justify the slight extra risk ( not enough alpha )?

As an illustrative example (with just round numbers pulled out of a hat):


80% Total Market, 20% 'safe' bonds, might be better than something like -

64% TM, 20% higher yield bonds, 16% 'safe bonds' ( reducing eq and bonds by 10% each)

or

70% TM, 20% higher yield bonds, 10% 'safe bonds' ( reducing eq and bonds by 10 points each)


OTOH, if HiYield has hit a low, that could maybe change that, you dirty market timers

BTW, I have a fair amount of HiYield - petty much just holding it on faith. I get my dividends, I assume the NAV will do OK in the long run. And if the above info is correct, I'm not going to sell now, for the same reasons others are thinking of buying.

-ERD50
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Old 08-01-2008, 09:23 AM   #17
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I've got a chunk of vanguards high yield. I dont mind getting the yield dumped into my checking account every month.

I guess the good question is what else you can find that pays twice as much as current cd rates and 4x current money market rates and has less risk than this fund.

Vanguards junk is very unjunky. In fact a few years ago the fund managers got nervous and unloaded everything above a certain risk level and moved their credit quality up too far and took a lot of crap from the investors for pushing the yield too low.

Way I look at it is that I'm not selling it. I like the steady income. I'm expecting to lose 1-2% a year like clockwork on the principal due to defaults. My net income after all that is better than the 'good' cd rates that have been around lately.

Do also note that I do the 'buckets' thing and this is in my first bucket alongside some other income producers and I fully intend to consume this bucket over the next 15 years. Its likely I'll still have plenty left in 15 years, but not necessary.
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Old 08-01-2008, 09:24 AM   #18
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Yes. Short-term high quality bonds provide the best diversification against equities for asset allocation purposes.

Audrey
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Old 08-01-2008, 10:05 AM   #19
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My equities are in my second bucket, due to be looked in on again in 2025 or so.

Only concerned about long term growth in that bucket. Diversification isnt relevant.

Isnt that nice? On one hand just worry about income for a period of time, on the other worry about long term growth.

No worry at all...
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Old 08-01-2008, 10:08 AM   #20
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I'm not sure it's the best time for junk yet, but I think we're getting pretty close.

One reason I'm not a big fan of junk is that its performance usually tracks small cap stocks fairly closely -- they are the first to recover sharply from a bear market, and the first to be taken out and shot as a correction is beginning. Both junk and small caps tend to exhibit this same behavior. So it seems to me that a combination of small cap stocks and high quality bonds would provide similar risk profiles, but quite possibly with less risk or higher total returns depending on the relative allocation.
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