Bonds have been taking a beating lately and certainly not
without reason. The economic data have been positive recently and
the increase in liquidity from QE2 will certainly put pressure on
inflation and thus interest rates.
However, it seems that while the current environment is negative
overall for bonds and much of the decline has been a justified
correction, investors are focusing overmuch on interest rate risk
and ignoring a positive trend in credit risk. The same liquidity
that creates inflation pressure also makes refinancing easier for
shaky firms. Furthermore, interest rates will almost certainly not
rise until there is a sustained recovery, which means that credit
risk and interest rate risk will not rise at the same time.
This analysis is supported by a recent report from Moody's
which, according to Bloomberg, found that
the global speculative-grade default rate fell to a two-year
low of 3.3 percent last month... as junk-rated borrowers tapped
the bond market at a record pace. The rate declined from 3.7
percent in October and 13.6 percent a year ago, Moody's said in
a report today. Defaults will fall to 2.9 percent by year-end
and 1.8 percent by November 2011, according to the report.
So which bonds stand to be least hurt in this environment of
rising interest rate risk and declining credit risk? High yield
bonds. Yet, during this period where investors have been shunning
bonds, high yield bond funds like [[PHT]] and [[DHF]] have fallen
by 11.9% and 8.1% respectively while [[BND]], an ETF that attempts
to measure the whole bond market, has fallen by only 2.2%. Now,
it's important to note that [[PHT]] and [[DHF]] use leverage and
were trading at high premiums above NAV a month ago and much of the
decline has been from that premium rather than from underlying NAV.
However, I am still struck by the fact that the large decline might
be an overreaction and that there might be a strong buying
To decide whether this is a deserved correction or an
overreaction and thus a buying opportunity, we need to consider
what the funds actually offer and how we can expect them to perform
As I've mentioned, interest rate risk is currently looming as
the largest risks facing bonds. On this measure, [[PHT]] and
[[DHF]] perform very well with an effective duration of 3.2 for
[[PHT]] and 3.8 for [[DHF]] compared with 4.8 for [[BND]]. This is
unsurprising since, if interest rates increase, high yield bonds
will have to fall by less in value than lower yielding bonds in
order to keep effective interest rates the same. What about credit
risk? It's hard to assess, but assuming that Moody's is right about
its projected default rate and the funds follow Moody's, then they
should have defaults of 3.3% of their portfolio. Assuming the worst
case scenario of zero return of principal in bankruptcy, then,
multiplied through by the leverage ratios of 1.4 for [[DHF]] and
1.5 for [[PHT]], they should lose 4.62% and 4.95% respectively off
Thus, assuming a worst case scenario where there is a 100 bp
increase in interest rates and they suffer defaults as mentioned
above, [[PHT]] should lose 3.2% from interest rates plus 4.95% from
defaults for a total of 8.15% while [[DHF]] should lose a total of
3.7% + 4.62% or 8.32%. That sounds pretty terrible, but we have to
consider the benefits side of this cost benefit analysis.
After the current correction, the market yields on [[PHT]] and
[[DHF]] stand at 11.38% and 12.4% respectively. Let's assume that
the interest rate increases happened all at once and all at the end
of 2011 (a near impossibility) so that they weren't able to spend
the money from their maturing debt on higher yielding debt and thus
increase their interest income. Let's also assume that the defaults
we mentioned above happened right away. That would cut interest
income to 10.8% and 11.95% respectively.
We see then that their high income would be enough to compensate
for even the very negative scenario laid out above and thus deliver
a net positive return on NAV. Furthermore, this analysis doesn't
even take into account subsequent years in which default rates
would fall and rising interest rates would gradually raise yields.
Thus, to answer the question "has this drop created a buying
opportunity?"-- the fact that it increased yields for buyers to the
point where they were able to compensate for potential losses
indicates to me that the answer is yes.
Now, is this price point the bottom? It's hard to say, but
probably not. However, looking for the bottom exposes you to the
risk that you miss out on what I believe is still an excellent
entry point. Buying now will get you a very large yield which can
cushion you against the many risks that face all bond investors.
Furthermore, it's very possible that the current rally is yet
another swing in a U.S. market whose long term destiny is to trade
sideways for quite some time. In that case, interest rates would
remain near zero, bonds would return to favor, and the current
price would look quite favorable indeed.
I have no positions in any stocks mentioned, but may initiate a
long position in
over the next 72 hours.
Are We a Nation of Financial Wusses?