Tuesday, March 31, 2009

Are Corporate Bonds a Screaming Buy?

I've had two "screaming buys" since I've started EconomPic. The first was on October 9th, with my post Muni Close-end Funds SCREAMING Buy? Since that date, the muni close-end fund I was tracking is up more than 40%.

The second screaming buy was on November 11th, titled Are Convertible Bonds a "Screaming Buy"? Since that date, convertible bonds are up 6%, significantly more than equities.

What this shows is two-fold:

  • My screaming buys are batting 1000
  • I'm lucky
Please keep in mind that there are no guarantees in this world (especially when that information is from a blog) BUT, with the price of corporate bonds implying default rates on investment grade rated bonds anywhere between 6-10% and those on high-yield corporate bonds between 30-40% (the wide range allows for a plug figure for recovery given default - the more money you get back given default, the less it will impact the pricing of a security), compared with the historical defaults below... corporate bonds are my next SCREAMING BUY.

EconomPic is far from alone on this call. In fact, Aleph Blog goes one step further:
At a time like this, I reissue my call to sell stocks and buy corporate bonds, even junk bonds. When the advantage of corporate bond yields are so large over the earnings yields of common stocks, there is no contest. When the yield advantage is more than 4%, bonds win. It is more like 6% now, so enjoy the relatively stable returns from corporate bonds.
A real threat I see in the short-run is that cheap investments CAN (and often DO) get cheaper. In addition, a lot of corporations are issuing new debt into an illiquid market, increasing the likelihood of short-term volatility. In the longer run a legitimate threat is the duration risk associated with corporate bonds (i.e. the likelihood of interest rates rising).

Overall, I am invested at a ratio of ~70% investment grade / ~30% high yield via an assortment of close-end funds trading at a discount. For the record I do not shy away from risk, so my recommendation would be to tone down the high yield exposure if you are more risk averse.

I hope I'm still be batting 1000 when I offer my next "screaming buy".

Source: Moodys


  1. I like you scenario, and I am also looking at buying junk bonds via closed end funds (slightly levered), although I do think you are early.....here is my reasoning: The actual default rate at the last couple of "light" recessions were 12-15%, and people are guessing that it was north 15% in the "great depression". If we can agree, that this downturn (deflationary debt destruction) is in the class of the great one, one might wait till the actual defaults are approaching the great one?
    According to s&p, we ended last year with a 4.8% default rate, so we have far to go...although a couple of GMs would get us there quickly. Also diversification of bonds is key....any ideas of how many and how to pick the closed end funds?

  2. Interesting observations Jake. According to K winter theory, mid way through the winter cycle, bonds become an attractive place to invest. Your data seems to back up that idea.

  3. fully agree with you that corporate bonds are to favour over stocks.

    but i´d like to add:

    do carefully look at what the "investment grade" ETFs are made of.

    an awful big part of "investment grade" bonds comes from financial issuers.

    without the backing of the government a lot of these companies would have blown up.

    there is no guarantee that bond holders will be protected forever.

    if the economy doesn´t recover the government might be forced to ask bondholders to share some of the pain.

    so i would look for funds that allocate most of the capital in NON-financial bonds.

  4. I second Green AB's comment on financials in the indices.

    Other than that, a careful allocation to bonds works for me.

    The spreads will have to decrease at some point, although the treasury rates could increase. At the moment, long bonds seems a lot safer than short treasuries. The later trade is very attractive long term, but has the potential to be toxic short term.

    Plus, regardless of expected values, the correlation of all these asset classes is high enough to need very high returns to justify investment.

    I am disturbed at just how many bets are essentially the same bullish bet on America, the American economy, etc.

  5. Definitely agree with this call and have been gradually adding to the play since november. For our readers, we had originally advocated LQD as its an easy way for the retail crowd to get involved. but, as others have pointed out, some of the ETFs are loaded with financial exposure.

    We've been trying to hunt down other vehicles to recommend to them, but are having tough luck. How diversified are the closed end funds you mentioned?


    By the way, first comment on your blog (long time reader) and just wanted to introduce myself. I'm Jay of marketfolly.com and I track hedge fund portfolios and mix in financial market commentary as well. Keep up the good work!

  6. I agree with your thoughts here and wonder if you would care to share what clesed end funds you are thinking about? How diversified are they and are they holding much in the way of financials? I too think that we are much better off if we can find CEFs that can generate high yield but can do it without loading up on financials. Green AB is certainly right about the likelihood of the government asking bondholders to share the pain at some point.