VGHighyieldcorporate treated as equity in portfolio. Crazy talk?

[cashflo2u2]

I read recently, can't remember where, but it was that the concept was to treat VG High Yield Corporate ( current yield is about 10.25%) as equity in the portfolio. Where they talking crazy or would there be something to this?

 

[DoubleDown]

I think I read over on the Bogleheads board that Larry S considers high yield funds 25% equity and 75% bond when figuring an AA.

 

[2B]

I have about 5% of my portfolio in closed end preferred funds that are currently yielding just under 20%. I treat them like equity in my AA. They've lost about 50% of their NAV this year but they are paying great dividends.

 

[brewer12345]

Depends on how junky the junk is, IMO. If we are talking about the clear, more stable end of the pool, I'd still think of them as bonds. If we are talking about moe volatile situations where the bondholders have a significant chance of ending up owning the company, I would treat them as equity.

 

[In-control]

I have about 10% of my AA in this fund and don't look at touching the capital portion. The monthly yield accounts for ~15% of my budget. The NAV has down significantly but when you look under the covers about 50% of the fund is in CD's and the remainder in known companies.

 

[ziggy29]

Junk bonds tend to act like a mixture of small cap stocks and investment-grade bonds.

I tend to treat them as bonds for simplicity, though I don't usually hold junk. (Junk has been rallying lately, though, and it tends to be one of the first asset classes to hit bottom and move higher. Whether it continues -- or if it's just a head fake -- remains to be seen.)

 

[ats5g]

cashflo2u2,

William Reichenstein, at Baylor, co-authored an article in the Spring 2008 edition of the Journal of Fixed Income titled "Returns-Based Style Analysis of High-Yield Bonds." Here's the abstract:

We present returns-based style analysis of four high-yield (HY) bond indexes and 60 HY bond funds. It is widely accepted that HY bonds are hybrid assets, with returns sensitive to both high-grade bond returns and stock returns. Our findings show they should be viewed as part high-grade bonds, part stocks, and sometimes part cash. Consistent with theory, as the credit rating decreases from BB to B to CCC, the bond component of returns decreases from about 73% to 48%, while the stock component increases from about 22% to 52%. Furthermore, there is a strong small-cap tilt in HY bond index returns. Our results reveal substantial differences among HY bond funds. Differences across funds in style weights are consistent with differences in the funds' holdings and investment styles. Returns of funds that invest more heavily in low-quality debt are more sensitive to stocks than funds that focus on BB or better bonds. There are notable differences in the strength of the small-cap tilts. Separately, some HY bond funds are more sensitive to growth stocks, while others show a value tilt. These findings should help investors better understand their true asset allocations and better manage their portfolios.

It was discussed over at the Bogleheads forum in May. You should be able to get a free copy through your local library.

In july I emailed Dr. Reichenstein the following two questions about the article:

Dr. Reichenstein,

I had a question or two about your Spring 2008 article on junk bonds in the Journal of Fixed Income.

1) If junk bonds are just a hybrid security of stocks and bonds, does adding junk bonds to an existing portfolio of stocks and high quality bonds add any value or make the portfolio more efficient? It seems like adding junk bonds to an existing portfolio of stocks and high quality bonds just confuses the stock/bond breakdown. I took the returns of Vanguard's junk bond fund from inception (1979) to 2007, and combined it with stocks (S&P 500) and intermediate term treasury notes. The junk bond fund only showed up in a few efficient portfolios, and even less when I added a small value tilt to the stocks.

2) From the asset location portion of your article, am I understanding correctly that holding any junk bonds in a taxable account is just like taking more equity risks in a tax inefficient manner?

and he responded:

1) Are junk bonds JUST a hybrid security of bonds and stocks? The R-squareds were well below 1.0, so they may add some diversification beyond high-grade bonds and stocks. But they certainly mess up the bonds-stocks asset allocation.

FYI, the Vanguard HY bond fund was more oriented toward BBB and BB bonds than most other HY bond funds; their "stock exposure" was relatively small. I do not own any HY bond funds. IF I did, it would be of a fund with an exposure to CCC and below bonds when the yield spread vs Treasuries was unusually high. But I do not think I will own HY bonds.

2) Yes, HY bonds essentially means you are taking more equity risk in a tax-inefficient manner.

- Alec

 

[ERD50]

Theory is nice, but this is how the NAV has *actually* held up (held down?) on VWEHX versus S&P500 for 2008:

That graph does not add in divs, so the junk would look ~ 7% higher, relative to S&P ( ~ 10% divs versus 3%). For my personal AA calculations, I look at VWEHX (or SPHIX - Fidelities junk bond - runs about the same) as 50/50 bond equity. Close enough for me.

-ERD50

 

[charlie]

Speaking of junk, there is an exchange traded debt security, FSF, which is bond issue of Financial Security Assurance Holdings Ltd. This bond has a par value of $25 but traded at $6.48 on 12/31. At that price it is yielding 21.6%. It has a call date of 7/31/2008 and matures 7/15/2103.

Financial Security is in the process of being aquired by Assured Guaranty who will assume the debt. Assured Guaranty has a AAA credit rating (stable) while Financial Security is rated A+ (on credit watch) as best I can figure out.

Even if the bond defaults, the odds are that you would get your $6.48 back.

This seems like a fantastic opportunity to me. Is it too good to be true?

Happy new year (and cheers)

charlie

 

[brewer12345]

Speaking of junk, there is an exchange traded debt security, FSF, which is bond issue of Financial Security Assurance Holdings Ltd. This bond has a par value of $25 but traded at $6.48 on 12/31. At that price it is yielding 21.6%. It has a call date of 7/31/2008 and matures 7/15/2103.

Financial Security is in the process of being aquired by Assured Guaranty who will assume the debt. Assured Guaranty has a AAA credit rating (stable) while Financial Security is rated A+ (on credit watch) as best I can figure out.

Even if the bond defaults, the odds are that you would get your $6.48 back.

This seems like a fantastic opportunity to me. Is it too good to be true?

Happy new year (and cheers)

charlie

charlie, how much do you understand about the issuer's business? I don't have a specific opinion on this name, so I cannot help you. But before I buy an individual bond with significant credit risk I try to have a thourough understanding of the issuer's business and credit profile. That typically includes:

- a detailed cash flow model
- a schedule of upcoming maturities that the issuer will have to meet and where they will get the money to repay them
- a sensitivity test as to how bad things have to get before default is likely
- a rough estimate of what my recovery could be in a bankruptcy scenario
- a thourough read of the bond prospectus and (if I can get it) the indenture, which helps show what protections are in place for bondholders

This stuff is all the more important with longer maturity bonds. And this one is really long.

There are any number of bond funds out there that traffic in this stuff in a diversified manner and even a bevy of closed end funds that trdae at a discount to NAV. So either do a proper job of doing due diligence, or diversify.

 

[charlie]

Hi Brew, thanks for the sanity check.

I found this issue on www.quantumonline.com. Acutally the issuer has
3 exchange traded debt issues FSF, FSE and FSB. The quantumonline site has a link to the prospectus, which I read ..... but probably did not understand.

I read the message boards on all 3 securities and all of the press releases.
What impressed me the most was that the company buying Financial Security Assurance (Assured Guaranty) has a AAA credit rating. I gathered from my research that Assured Guaranty will assume the debt.

If true, and if the aquisiton goes through, would not the credit rating of the securities increase causing a significant price increase?

This company is under a cloud because of the credit mess and because of the conventional wisdom that bond insureres time has past. But my understanding is that they intend to foucs on the municipal bond market in the future .... and did not Warren Buffett put a foot in this market recently?

One other point that I picked up is that the "troubled financial products"
part of their business is supposed to remain with Dexia, the current owner of Financial Security Assurance.

Finally, it seems to me that the very long maturity is a plus, not a minus in this case for the simple reason that they are under no obligation to retire the debt any time soon.

Brew, thanks again for responding. I plan to do more due diligence before plunging.

Cheers,

Charlie

 

[brewer12345]

Hi Brew, thanks for the sanity check.

I found this issue on www.quantumonline.com. Acutally the issuer has
3 exchange traded debt issues FSF, FSE and FSB. The quantumonline site has a link to the prospectus, which I read ..... but probably did not understand.

I read the message boards on all 3 securities and all of the press releases.
What impressed me the most was that the company buying Financial Security Assurance (Assured Guaranty) has a AAA credit rating. I gathered from my research that Assured Guaranty will assume the debt.

If true, and if the aquisiton goes through, would not the credit rating of the securities increase causing a significant price increase?

This company is under a cloud because of the credit mess and because of the conventional wisdom that bond insureres time has past. But my understanding is that they intend to foucs on the municipal bond market in the future .... and did not Warren Buffett put a foot in this market recently?

One other point that I picked up is that the "troubled financial products"
part of their business is supposed to remain with Dexia, the current owner of Financial Security Assurance.

Finally, it seems to me that the very long maturity is a plus, not a minus in this case for the simple reason that they are under no obligation to retire the debt any time soon.

Brew, thanks again for responding. I plan to do more due diligence before plunging.

Cheers,

Charlie

Assured Guaranty may currently have a AAA rating, but it could be changed at any time as many have found to their chagrin. So if the deal does not happen or Assured falls on hard times, what is the likely outcome for you as the bondholder? I don't know, since these companies have extremely complex liabilities that are not even fully disclosed enough for us to figure it out.

If the deal does go through and Assured remains healthy, it isn't clear to me that there is a municipal bond insurance market left any more. Could be, but who knows?

The problem with the long maturity isn't for the issuer, it is for the bondholder. To make an extreme example, imagine a company has a 1 year bond and a 100 year bond out. In many cases, I can probably figure out what kind of shape a company will be in in a year. But I would not care to hazard a guess what the story will be in 100 years.

You might be right: the bonds could be a steal. But its hard to tell if this is really the case. In a world where far less spooky bonds are offering double digit yields, I would not touch this one with a 10 foot pole even though it might be money good.

 

[saluki9]

Speaking of junk, there is an exchange traded debt security, FSF... and matures 7/15/2103.

94 years to maturity? No wonder investment bankers love individual investors.

 

[charlie]

I am looking at these securities (FSE, FSB, FSF) as a speculative play.

There is decent volume so I think I can sell anytime I want. They are
traded like stocks on the NYSE so you don't have to contend with large
bid-ask spreads.

Warren Buffett likes this business and Wilber Ross, who ownes a big chunk of Assured Guaranty (in process of buying FSA from Dexia) likes it too.

Reuters reported that S&P will take FSA off credit watch if the deal goes
through.

I think you are looking at a potential 3-banger at the current price levels
if the deal goes through. In the meantime, 20% yield while you wait is
not bad.

If the deal does not materialize, then FSA will probably be downgraded
and FSA stock will drop like a stone. Buffett will then step up and buy
the company (IMHO, of course).

Even If FSA goes bankrupt, I think there is a good chance of getting your
money back (inconvenient though it may be).

This is all just speculation on my part so do your own research and form your own opinion.

As for me, I think I will take a little nibble.

Cheers,

charlie

 

[haha]

As for me, I think I will take a little nibble.

I hope this works out very well for you, and it may well. For me, the flaw is in the what you expressed above-"a little nibble". Unless you are just buying a lottery ticket and putting it in the drawer, it is hardly worth the effort you will have to go through to understand this thing and keep yourself updated, unless you take a big gulp. And if you take a big gulp you might just drown.

94 years to maturity? No wonder investment bankers love individual investors

BTW, what is the maturity of a common stock?

Ha

 

[brewer12345]

BTW, what is the maturity of a common stock?

Ha

Nicely skewered. I would suggest that the hundred year bond in question is very equity-like in terms of risk-reward and likely volatility.

As for charlie, if you want a fling that's OK. I think you would be ill-advised to bet the farm, though.

 

[saluki9]

BTW, what is the maturity of a common stock?

Ha

Still makes my point perfectly. So the company can tie up your investment for 100 years and never give you a cut of the profits. Brilliant if you can [-]sucker[/-] convince people to invest.

 

[saluki9]

Nicely skewered. I would suggest that the hundred year bond in question is very equity-like in terms of risk-reward and likely volatility.

As the people who bought them at par, I'm sure they would agree on the risk side of that equation.

 

[brewer12345]

Still makes my point perfectly. So the company can tie up your investment for 100 years and never give you a cut of the profits. Brilliant if you can [-]sucker[/-] convince people to invest.

Arguably, the credit spreads are so wide that any modest improvement in the company's business/prospects will be dramatically reflected in the spreads (and prices) of its bonds. This is distressed debt investing 101.

 

[saluki9]

Arguably, the credit spreads are so wide that any modest improvement in the company's business/prospects will be dramatically reflected in the spreads (and prices) of its bonds. This is distressed debt investing 101.

I am aware of that. My comment was made to the original investors only.

 

[brewer12345]

I am aware of that. My comment was made to the original investors only.

Yield hogs generally get slaughtered.

 

[clifp]

Well if I was a vampire, a 100 year bond might make sense, since I could actually hold it to maturity. For us mere humans it seems like I am taking all off the risk (interest, inflation, default) and for a very modest upside. At the current pricing levels it looks more interesting. Although, I would point out that one of the lessons I've learned the hard one durning this market is that material improvements in a companies/securities prospects aren't necessarily reflected in the prices. Especially when the situation goes from very bad to simply bad.

So even though the company is being acquired by a AAA company perhaps the market still has doubts that debt will be paid. For instance when BAC of Countrywide, BAC said that wouldn't be taking over all of Countrywide's debt. I am not sure what actually happened but Countrywide debt didn't rally.

 

[brewer12345]

"Very modest upside"? I can't say I would be eager to buy these bonds, but there is upside if things go well. 20% or so cash on cash yield plus potential appreciation of 100% or more sounds pretty good to me. I have recently bought some bonds that offer similar potential returns.

 

[haha]

Well if I was a vampire, a 100 year bond might make sense, since I could actually hold it to maturity. For us mere humans it seems like I am taking all off the risk (interest, inflation, default) and for a very modest upside.

Giving weight to the very high current yield, it seems that the main risk here is credit, not interest rates. While the maturity is long, duration is much less so. If this bond holds together it has less interest rate/deflation risk than a 20 year treasury at current quotes.

Ha

 

[clifp]

Sorry I wasn't clear I was talking about the individuals who bought the 100 year bonds when they were initially offered, presumably near par. I don't understand why anybody would buy a 100 year bond, stock also has no maturity but you share in the upside...

At current yield these bonds clearly have a excellent upside. In fact despite the low stock market levels I think there are a lot of debt out there that is offering 15-25% yields that looks more interesting than stocks. In a couple of case I sold stock and bought debt of these companies.

I wish I had Brewer's knowledge of how credit markets work. I think you could end up with a high (say 20-40%) default rate and still make on an excellent return on debt of the companies that manage to get through the recession.