You Swear You’d Never Buy ‘Junk,’ So Why Do You Own So Much?

Corporate Bonds Before “Junk”

Labels can mean a lot. A wrong, or misleading, or even nasty label can follow a person through life and cause a lot of unhappiness or missed opportunity.

That’s basically what happened with the term “junk” when it was first applied to bonds issued by non-investment grade companies back in the 1980s.

Before then there was no real market for the bonds of companies that were not rated “investment grade,” which meant ratings of AAA, AA, A and BBB. The typical bond investor was buying either (1) a Treasury bond, which carried essentially no credit risk since it was issued by the US government, which could print unlimited quantities of dollars to pay it off at maturity; or (2) an investment grade corporate bond which, of course, does carry some credit risk, but a pretty minimal amount, since investment grade companies seldom default, relative to non-investment grade companies.

That meant investors in Treasury bonds were (and still are) being paid solely to take interest rate risk, the very real risk of rising interest rates leaving them with either a sub-standard yield if they hold until maturity, or a capital loss if they sell before maturity. Corporate bond investors are taking the same interest rate risk of Treasury bond investors with similar maturities, and the differential in yield between their corporate bond and the equivalent-maturity Treasury bond represents how much extra yield they are being paid to take the credit risk.

That differential – the extra amount above Treasury yields that corporate bond investors receive for buying investment grade bonds – isn’t much. So the “bond market,” as it existed up until the 1980s, was not so much a “credit” market as it was an “interest rate” market. That continues until today, and is why investment grade bonds don’t represent much of an opportunity to a real “credit investor,” once you back out the interest rate risk and what you are paid to take it.

For example, the 20-year Treasury bond rate is currently about 3.5%, while the 20-year corporate bond rate is currently about 4.8%. That means the corporate bond investor is only earning an extra 1.3% for taking the credit risk of the corporate issuer.

Enter High-Yield Bonds

In the 1980s when Michael Milken and his colleagues at Drexel Burnham began to underwrite bonds for corporations rated less than investment grade (i.e. BB+ and lower), it represented a major change in the corporate finance market. Prior to that, the only public corporate bonds below investment grade were so-called “fallen angels” that started out higher and had their credit deteriorate to the point where they were no longer investment grade.

But raising public debt for companies that were already non-investment grade? That was a pretty radical idea by this upstart group of investment bankers at Drexel. Folklore has it that Michael Milken himself may have coined the term “junk bonds” to describe these issues that, unlike Treasury and investment grade bonds, actually carried serious credit risk.

But it is hardly surprising that the market embraced the term, not in spite of, but because of, its derogatory connotations, since many long-time bond market professionals did not look all that kindly on a new asset class that threatened to up-end long-established market traditions.

For example, for decades the insurance industry had been virtually the sole source of long-term, fixed-rate debt for non-investment grade companies, since they were shut out of the public bond market. This “private placement” market, dominated by major insurance company lenders like Prudential, John Hancock, Mass Mutual, Connecticut Mutual, Equitable and many others, had a lot to lose if their corporate client base all of a sudden had a public bond option not previously available to it.

And commercial bankers, who typically provided the short-term bank loan finance to these same companies, worried about losing their tight relationships with non-investment grade clients (which meant most clients, since the great majority of all corporations are non-investment grade). That’s because traditionally it was the commercial banker who would arrange the introduction to the local insurance company when the bank-loan client was ready to expand their financing to include longer-term debt.

So there were plenty of players in the market at that time who were probably eager to embrace and attach a somewhat pejorative nickname like “junk” to this new corporate capital market that threatened the existing status quo.

A Real Credit Market

The new, so-called “junk” market, that emerged in the 1980s and since, was a real credit market. The terms on high yield bonds are generally only 5 to 10 years, a lot shorter than the 20 years or more that is common in the higher-grade Treasury and corporate bond market, so they carry a lot less interest rate risk. Many of the high-yield funds we own have average maturities in the 5-year range, so that as interest rates increase, about 20% of the portfolio is maturing and re-pricing at the increasing rates every year, much faster than the repricing of a traditional bond portfolio. That means much more of the higher yields these non-investment grade corporations pay investors actually compensates them for taking credit risk, rather than interest rate risk. (The current average high yield bond yield, according to the St. Louis Federal Reserve Bank, is 8.3%.)

With yields of 8% and more, high-yield bonds, especially when we buy them in closed-end funds where the additional advantages of discounted prices and cheap institutional leverage add to our potential yield, can become an equity-like candidate in terms of potential long-term return.

We know the average equity investor, if they stay fully invested over the long term, is likely to earn about 9 or 10%. But that includes a lot of volatile, “white knuckles” periods like the one we’re currently going through, where their portfolio only yields a puny 2% or so, and the growth is (temporarily, we hope) on “hold.”

High yielding credit assets, like senior corporate loans, HY bonds, convertible bonds, collateralized loan obligations (“CLOs”), and similar credit assets, can be held in closed end funds or through business development companies (“BDCs”), with yields of 8 to 10%. That lets us create our own income growth by reinvesting and compounding through volatile market periods, essentially earning an equity return, but with a less volatile, more predictable asset class.

Institutional investors have been doing this for many years, and it is also a core aspect of our Income Factory® strategy, as many readers know.

Overcoming the “Junk” Hurdle

Credit investing involves confronting the “junk” label, and many investors are challenged by this. Having grown up in the banking and credit arena, long before I ever came to the more traditional equity investing world, I am more familiar with the ins and outs of credit, and especially how the math works to make it less scary than the terms like “junk” and “default” and “loss” sometimes suggest.

Here are some basic facts that high yield investors, actual and potential, should understand.

• The great majority of corporations that borrow from banks, issue debt and equity in the market, and that most of us know and whose products and services we are familiar with, are non-investment grade companies (i.e. “junk”).
• Many, perhaps even most, investors who hear the term “junk” and swear that it is too risky, do not even realize that they already hold many of these same companies in their equity portfolios.
• Yes, that’s right. Any investor who holds a “mid-cap” or “small-cap” stock fund owns “junk” since very few of the companies in either of these two categories would be investment grade; they would virtually all be “junk” (as would about 10% of the companies in an S&P 500 index as well)
• Of course, the stock in these companies is far riskier than their debt (i.e. their high yield bonds and/or loans), since debt has to be repaid or the company goes bankrupt and its equity is then worth zero (even though the defaulting debt, in bankruptcy, often collects 40-50% of its principal, if bonds, or 70-75% if it’s a loan)
• Fortunately, investors can rest somewhat assured about their small-cap and mid-cap stock investments, as well as their high-yield bond and stock investments, because even among non-investment grade companies, defaults are relatively rare.
• In the 2008/2009 recession (the so-called “Great Recession”) defaults reached a peak of about 10%. That meant 90% of a diversified portfolio did not default, and kept on pumping out its interest. If we assume the 10% that did default probably repaid about 40% or so to its bond holders (i.e. lost 60%), and about 70% to its secured loan holders (i.e. lost 30%), that means the loss for bondholders would have been 10% times 60%, or 6% of the portfolio; and the loss for loan investors would have been 10% times 30%, or 3% of the portfolio. That’s less than 1 year’s income for both of them, which is far less than most equity investors would lose in a similar economic scenario.
• In more typical, non-recessionary periods, defaults often range in the 1 to 3% range.
• More important, the 90% of high yield bonds and loans that did not default in the 2008/2009 recession saw their secondary-market prices drop to 60-70 cents on the dollar, which meant investors (including funds) that held them could collect the repayments received from the healthy 90% and reinvest in other healthy loans on the secondary market at bargain prices, which turned into capital gains a couple years later when those loans matured at par.

Bottom Line

Credit investing has its risks. But no more, and arguably much less, than equity investing. Don’t let the term “junk” scare you. Also, don’t forget what we’re betting on when we invest in debt versus what we are betting on when we buy stock. With debt, all the company has to do is stay alive and pay its debts, and we win the bet. With equity the company has to do all of that (stay alive and pay its creditors), and then on top of that it has to grow its earnings. Which bet do you think is a lot easier to win? (If you find this topic interesting, check out this article.)