The latest headlines about 'junk' bonds are a classic case in point. You don't need to be a dedicated contrarian investor to get a bit uneasy when you read them.
In fact, there's such a buying frenzy now underway, it could even make sense for more adventurous investors to sell junk bonds 'short'. Here's how...
"Buy to the roar of cannon, sell to the sound of trumpets". This was the advice that British banker Lord Nathan Mayer Rothschild gave during the Napoleonic Wars on how to make the most of your money.
And it applies just as much today as 200 years ago. History shows that the right time to buy into a market is when financial Armageddon looms. And the time to get out is when the jitters have passed, and everyone's feeling upbeat again.
By March 2009, many investors had lost so much money in the stock market that they didn't want to know about buying shares. But if anything, they'd come to hate 'junk' bonds – lower grade IOUs issued by companies to raise cash – even more.
Even although these bonds rank higher in the pecking order for creditors if a business goes bust, prices collapsed as 'risk aversion' among investors soared.
The flip side was that the yields on some of the dodgier corporate issues climbed well into double-digit territory (bonds pay a fixed income, so when prices fall, the income yield rises). Basically, markets were saying that we were about to see an avalanche of bond issuers defaulting on their interest bills.
Some of these recession-induced jitters were understandable. Company cash flows, particularly in the US and Europe, were being savagely squeezed by falling sales and lower profit margins. In fact, by the end of 2009, the global default rate for high-yield debt hit 13%. In other words, one in seven junk bond issuers proved unable to service its debts.
Despite everything, junk bond prices have surged
But look what's happened to junk bond prices over the past year. March 2009 was, with the benefit of 20/20 hindsight, exactly the time to buy into the junk bond market, despite all those concerns.
Prices have surged, so yields have dropped sharply. High-yield bonds now pay out an average of 8.6%, says Bank of America Merrill Lynch. This may still look like a decent return, but it's actually the lowest since October 2007. That, by the way, was just before financial markets fell apart last time.
And 'spreads' – the difference between yields on junk bonds and US Treasuries – have now narrowed to their lowest levels since December 2007.
Is there much justification for this? Well, there's been a slight improvement in terms of defaults. By the end of this year's first quarter, the default ratio had dropped to one in ten (from one in seven), and is forecast to fall further throughout 2010. So fewer companies are under the cosh. But a 10% default rate is still hardly anything to cheer about.
Yet now, it seems investors just can't get their hands on enough junk. These bonds account for "the biggest share of corporate debt sales on record" reports Bryan Keogh in BusinessWeek. "Global high-yield bond sales hit $91bn this year, or 12% of total issuance, almost double last year's share, according to Bloomberg data. Investors wagering on an economic rebound are snapping up securities even from first-time issuers".
In other words, investments that couldn't be sold for love nor money a year ago are currently being bought with relish. Yet potential returns are now much lower, and some of the sellers have no market track record.
"Most of the major concerns seem to be gone", Calvert Asset Management's James Lee tells Bloomberg. "It's a self-fulfilling cycle. Cash is coming into high-yield, and high-yield managers are putting cash to work". Indeed, "it's hard to find debt that investors don't like", says Agnes Crane on Sify Finance.
Alarm bells should be ringing for contrarians
Cue Rothschild's trumpet blasts – it's time for contrarians to get worried. "Lenders don't seem to be good learners", says Crane. "To judge from the credit market, the 2008-9 crisis might never have happened. The current buying frenzy looks like a return to an old bad habit".
There may be plenty of junk bond buyers chasing yields down right now, but there are plenty more borrowers in the pipeline. We flagged in the magazine last month that $700bn of dodgy debt in the US alone will mature between 2012 and 2014, and so will need refinancing: Why 2012 really is doomsday.
Compared with just $21bn maturing this year, that will be "an extraordinary surge", says Nelson D Schwartz in The New York Times.
More corporate borrowers will have to compete with each other, as well as with cash-strapped governments, for whatever funds will be around. And as lending risks rise, much higher junk bond yields around the world look likely. Borrowers will "get crowded out or will have to pay significantly more", says Tom Atteberry of First Pacific Advisors.
All bad news for junk bond prices. But as an investor, what should you do?
How to cash in on the the junk bond boom
Clearly, not joining in the junk bond party will stop you losing your cash in it. But there is also a way you can make money here.
The ITraxx Crossover 5-year Total Return Index is a measure of the default risk of 50 of the most liquid European High Yield corporate bonds. As investors' fear of default falls, and junk bond prices rise, the Index goes up, as has happened recently. The Index is almost at its highest level since Bloomberg records began in 2006.
But if default worries resurface and junk bond prices decline, the Index will fall. And if you want to buy something that will take advantage of such a drop, the less than snappily titled db x-trackers iTraxx Crossover 5-year Short Total Return Index ETF (GY: XTC5) should do the trick. That's because it's effectively selling the Crossover Index 'short'.
It isn't without risk. Selling short rarely is, and you lose money if the index keeps rising. It's also quoted in euros, so there's currency risk too, if the pound recovers. It's also worth having a look at the detail of the ETF's construction to ensure you understand how it works. But if you believe the junk bond boom is nearly over, this could be a good way to cash in.
From money week published on Apr 12, 2010