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Barrons – It’s Time to Talk Trash

By ANDREW BARY | OCTOBER 8, 2011
The junk-bond market has taken a big hit. It might fall some more, but patient investors will be rewarded. Anyone in search of income should take advantage of the hefty yields.

The junk-bond market lately has suffered its worst spill since the 2008 financial crisis, with the yield on a key index topping 10% last week, up from 7% in May, amid concerns about the global economy.

There have been particularly steep declines in debt of highly leveraged companies such as Harrah’s Entertainment, Clear Channel Communications, First Data, Energy Future Holdings and Realogy, which were taken private in top-of-the-market leveraged buyouts from 2006 to 2008. These bonds can carry yields in the mid-teens—or higher—as investors worry that the companies may need financial restructuring to cut debt.

The selloff has made junk appealing. Since the end of July, prices (which move inversely to yields) have slid 10%, with major indexes now off 3% for the year. The spread, or yield gap, between junk and U.S. Treasuries stood at nearly nine percentage points last week, versus 4.75 points at the end of April, based on the BofA Merrill Lynch High Yield Master II index.

“There’s massive value in the high-yield market,” says Dan Janis, a senior portfolio manager of the John Hancock Strategic Income Fund (ticker: JHFIX), which has about 35% of its portfolio in junk. U.S. default rates are running at just 2% annually. While that rate probably will rise in the next year or so, junk offers ample yield to compensate for the risk.

Prices of preferred stock issued by many financial companies also are down. Bank of America, the leading preferred issuer with $38 billion outstanding, offers yields as high as 9.5%. Its 7.25% series L issue trades around $760 (versus a $1,000 face value). Warren Buffett’s Berkshire Hathaway bought $5 billion of BofA’s 6% preferred last month.

Citigroup trust preferred yield almost 7.5%, while Ally Financial, formerly General Motors Acceptance Corp., has exchange-traded debt (including tickers GJM and GMA) yielding over 9% and preferred yielding 12%. American International Group’s 7.7% subordinated debt (AVF) yields 8.5%.

One rumored factor in junk’s decline is selling by Japanese “double decker” funds, which hold junk with a high-yield currency kicker, often the Brazilian real. Barclays credit analysts have estimated that these funds, sold to Japanese retail investors, may account for 6% to 9% of the buyers in the $900 billion high-yield market. Many of these funds have fallen 25% since late July, as junk prices have crumbled and the Brazilian real has slid against the dollar and yen.

Widening Gap
After shrinking sharply, the difference in yields on junk and comparable Treasuries is now almost nine percentage points.

The $19 billion Loomis Sayles Bond Fund (LSBRX) now has a 30% exposure to the junk market, compared with its average around 20%. “It’s an attractive area of the bond market. It could get a lot more attractive,” says Kathleen Gaffney, the fund’s co-manager. Historically, junk usually has weakened further after spreads crack eight percentage points. “The market is pricing in a recession and much higher defaults than we have been experiencing,” she says.

The MainStay High Yield Corporate Bond (MHCAX) is positioned more conservatively than its peers. “We talk to companies,” says manager J. Matthew Philo. “We don’t listen to Wall Street economists. Developed-world economies aren’t doing very well.” But Philo is partial to debt of Texas Industries (TXI), a cement maker whose 9¼% bonds due in 2020 trade around 75 for a 14% yield. He also likes higher-quality bonds like Georgia-Pacific (the forest-products company) and Charter Communications (CHTR, cable TV).

He’s avoiding debt-burdened LBOs like Harrah’s bellwether 10% bonds, due in 2018, which fetch just 67 cents on the dollar, for a yield of 18%. Harrah’s, now called Caesars Entertainment, is burning cash and has debt equal to more than 10 times its annual pretax cash flow. High-grade companies usually keep debt to no more than three times cash flow. “Some of these LBOs may not make it,” Philo warns. “They’re not capitalized to weather an extended weak period in the economy.”

There are lots of ways to play the junk market, including open-end, closed-end and exchange-traded funds and funds that buy bank loans, the most secure debt of leveraged companies.

Big open-end funds favored by Morningstar analysts include Fidelity High Income (SPHIX), T. Rowe Price High Yield (PRHYX) and Vanguard High-Yield Corporate (VWEHX). The two major junk ETFs, the SPDR Barclays Capital High Yield Bond (JNK) and iShares iBoxx $ High Yield Corporate (HYG), yield around 8%.

In sum, this is a good time for investors to gain some exposure to the high-yield market. Junk could go lower, but even if it does, patient investors may be rewarded.

Rewards of Risk
Some junk bonds offer yields in the teens, but risk rises with the potential reward. The yields shown represent a broad swath of each issuer’s bonds rather than a specific security. Here are the leading junk issuers.

Issuer Yield Ratings

Moody’s

Ratings

S&P

Ford Motor/Ford Credit

5.76%

BA2 BB-
CIT Group

7.22

B2 B+
HCA

7.44

B2 B+
Ally Financial (GMAC)

8.81

B1 B+
Sprint

9.46

B1 BB-
Energy Future Holdings

21.30

CAA3 CCC-
American Intl Group

8.73

B1 BBB-
First Data

16.26

CAA1 B-
Intelsat

11.26

CAA1 B-
Reynolds Group

10.21

B2 B+
Harrah’s

17.69

CAA1 CCC+
Charter

7.21

B1 BB-
MGM

9.22

B2 B-
Clear Channel

15.86

CAA1 CCC+
AES/Ipalco

8.29

B1 BB-

 

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