This morning, I did what I always do to start the day. I flipped on the television to the financial network and sat down to read the news of the day. I was a little dismayed to see that the Detroit Tigers had overcome the Texas Rangers last night. Although the Detroit-rising story line is compelling, having a Texas born wife leads me to favor a Rangers win and marital bliss. The news of the morning contained no real surprises. Pepsico (PEP) posted a solid quarter as foreign markets were strong enough to offset relative weakness here at home. A headline I never thought I would see told me that stock futures were rallying, as traders hoped for good news out of Slovakia. All in all, it was pretty normal news for the world we live in right now.
But an article in the Financial Times this morning made the case that junk bonds are undervalued and priced for a deep recession. That disturbed me greatly. The article points out the junk yields are now at above 9% and trading at a 800-basis-point premium to Treasuries. The article also says the real returns are very high historically -- if you assume a 40% recovery rates for defaulted bonds. This may be moderately useful analysis if you are running a multi-billion bond fund and junk bonds are a small part of your total portfolio, but for those of us who are seeking opportunities with far less money, junk bonds do not look all that cheap to me.
I am not an everyday bond trader. However, over the years, I have been attracted to the junk markets when they looked they were priced for the end of the world -- this is when most bonds trade no bid and everyone is trying to sell bonds at any price. In the aftermath of the Milken-inspired, junk-bond blowup, we were buying with both hands paper issued by bankrupt nuclear utilities, airlines and Texas real estate concerns. After the Internet bust, we were buying junk bonds at outrageous prices that pretty much guaranteed a positive. Although I was nowhere near as active as I should have been in 2008, I was able to buy situations such as Forest City Senior debentures. I paid less than 25% of face value for bonds that never missed a coupon. If the company had defaulted, I was pretty confident the real estate could be liquidated for close to twice what I paid for it.
High-yield markets are not priced for anything close to a deep recession, much less the end of the world. In absolute term, the 9% yield on the Bank of America-Merrill Lynch High-Yield index is at about the middle on the long-term range. Yields could fall a lot further if investors begin to exit the marketplace. In the post Internet era the index yielded about 14%. In 2008, they spiked to over 20% for a period of time. If you are running a relative value bond portfolio, junk might be a buy, but it does not appear to me that an absolute-return, margin-of-safety oriented investor should be buying much high-yield paper at these levels.
The article made me curious enough to go look for bonds that were priced at above-average yields to see if perhaps I was overlooking something in my views of the market. I use the bond screener at FINRA.com to run a simple screen looking for bonds selling below $0.80 on the dollar with double-digit yields.
The bonds I see trading at these levels are the ones I would expect to find. American Airlines' (AMR) paper is trading at junk levels right now. As the company is the subject of a bankruptcy rumors, it should be. However, most of the bonds trade well above the anticipated recovery rates of $0.40 on the dollar and there is no margin of safety in the bonds that I can see. Rite Aid (RAD) has some long-term debentures trading at double-digit yields trading at $0.60 on the dollar. If the company were to file for bankruptcy, the recovery rate on this paper would not be anywhere near that level.
I do not see any junk bonds that are trading above high yields or a potential recovery rate anywhere near the current price. In short, junk bonds do not represent an opportunity for absolute-return vulture investors at current levels.