Default to High Yield

This morning I was explaining high yield bonds to my daughter. To get my point across, I had to use a practical application. A high yield bond is like lending her money and expecting to get paid back. How much extra would I have to charge her to compensate me for the risk that I might not get my money back vs. lending money to my Dad? Companies who are viewed as having more risk of non-payment (default) will have to pay a higher interest rate than those who are top rated by Moody’s Bond rating or any other independent bond-rating agency. Typically, BB rated or lower denotes high yield depending on the agency.

If we look at HYG-N which is an exchange traded fund traded on the New York Stock Exchange, we can see a steady rise from the low in March. It closed at $62 on March 6, 2009 and is now trading at about $86, which is about a 40% return. The current yield is 9.66%. Not a bad return considering it is arguably less risky than the equity market. The only other consideration is currency risk, which has been a drag on performance by about 20%. With the exception of few brief periods, the current price has maintained it’s position above the 50 day moving average and should be a good proxy for support at this level or just below it. If the current price breaks below the 100-day moving average, that might be viewed as the trend breaker. Relative strength has fallen back to the mid 40’s from it’s high of 84. MACD looks to be positive at this point. The technicals still look positive.

Looking forward, it is good to analyse how these corporations are fairing in the financial crisis. An article in the Wall Street Journal (WSJ.com) dated November 16, 2009 by Mike Spector and Kate Haywood; “Bankruptcy Rise Slows With Thaw in Lending” explains how default rates are falling. “These companies are now refinancing their balance sheets with new debt, pushing out maturities on existing loans or using distressed-debt exchanges to avoid bankruptcy filing…. Many analysts worry the refinancing wave is just ‘kicking the can’ down the road without fundamentally fixing companies’ deeper problems.” Some high yield bond fund prices reflected over 20% default rates earlier this year. “Now, Moody’s expects the U.S. default rate to peak at 13.6% this month and fall to 4.4% a year from now.” Although one could perceive that as being rosy, the challenge is moving from debt for refinancing to debt for growth. With high unemployment and an unpredictable consumer, it’s hard to see where the growth in revenues will come from. After all you can only cut expenses so far to increase profits. If we have another setback like what we experienced, you will see the price of high bonds fall also but not likely as much as stocks. Therefore, high yield bonds are an alternative to stocks and government bonds that will give you a higher cash flow. If the markets go south, you have some downside protection with the cash flow from the yield.