It's Time to Add Some Junk to the Trunk

As I noted last week the yield spread between so-called junk bonds and Treasury bonds has been narrowing over the last several weeks. I said it was a sign that the global credit crisis is healing, and that it might point the way forward out of recession. But it's more than that. It's also an investment opportunity.

According to John Lonski, chief economist at Moody's Investor Service, the yield spread of 20.25% on Dec. 16 is a record, as far back as his data go. That means on that date you could've bought noninvestment-grade corporate bonds yielding 20.25% more than Treasury notes.

The previous record was October 2002, the same month as the bottom in stocks that turned out to be the launch pad for the 2002-07 bull market. Then the yield spread was 11.5%, just a little more than half of what it was last month.

With the spread at 20.25% in December, total yields would've been about 21.5%. It's pretty sweet to think about locking in that kind of income stream. But it wouldn't have been exactly a lock. There would be plenty of risk -- that's why these bonds are called noninvestment grade, or "junk." Their issuers are smaller or more volatile companies that face a higher likelihood of defaulting on their bonds than larger or more stable ones.

Lonski says that the default rate for these bonds has been quite low over the last year, even though the global economy has been under extreme stress. Only about 3.5% of bond issuers have defaulted, well below the historical average. But Lonski thinks that by the time 2009 is done, the default rate will rise considerably, to something like 11%.

OK, you might be thinking that wouldn't necessarily be such a bad thing. You get a yield of 21.5%, so you'd still keep about half that if 11% of the companies went under. By the way, to put that in some context, Lonski says that at the worst of the Great Depression about 15% of issuers defaulted. So 11% would seem to be already anticipating nearly the very worst that could possibly happen.

But still, even that 11% puts a real premium on picking the right companies, or at least not picking too many of the wrong ones. If your particular portfolio of junk bonds has more losers than average, you could still get hurt.

But even that isn't a perfect solution. When Lonski says 11% of issuers will default, that doesn't mean that only 11% of the value in the junk bond market (or your investment) will be lost. It depends which companies default. That's because there are a few issuers that account for a disproportionate share of the value of the market.

For example, Lonski points out that the four bond-issuing entities of General Motors (GM) and Ford Motor (F) account for about 10% of the market. So if just those four issuers default -- less than 1% of the 600 total issuers -- 10% of the market is wiped out.

There are some solutions. You can do what I do, and invest in mutual funds that specialize in junk bonds. Highly diversified ones will pretty much assure that your default experience will be about the same as the average default experience.

The one I invest in is the Vanguard High Yield Corporate Fund (VWEHX). I like it because it's broadly diversified, because it has low fees, and also because it's somewhat conservative -- at least as conservative as a junk bond fund can be. My yield won't be as spectacular as if I were willing to invest in the riskiest of the risky. But as the old saying goes, everything in moderation.

Lonski thinks that may be the smartest strategy at the moment, in terms of where the value is. He notes that within the universe of junk bunds, you don't get all that much extra yield by holding the very riskiest ones. He thinks the sweet spot now may be at the high end -- the least junky of the junky.

There's another way to think about junk bonds that goes beyond locking in yields and worrying about defaults. If you want, you can treat them as a speculative vehicle. Since the high-water mark for junk yields in mid-December, the Vanguard fund has appreciated almost 15%. If, as I do, you think that yields are going to continue to come down as the credit crisis eases and markets come back to normal levels of volatility, there's probably another 15% or so to be made in junk over the coming few months. If that happens, take your profit and run. That way possible future defaults are someone else's problem.

The magic of junk-bond yields is that, from the high levels where they are today, the lower they go the lower they will continue to go. It's a virtuous cycle. When yields are super-high, there's no new issuance, because companies can't afford to raise money at such punishing rates. So some perfectly good companies get into trouble simply because they can't raise money, and that in and of itself can contribute to defaults.

But as rates fall, it becomes easier for companies to finance themselves, and that in and of itself makes these companies more creditworthy. So the default rate goes down, and that drives yields down even more. And so on, and so on.

In a recession, the only cycles anyone wants to talk about are vicious ones. I hear over and over about how rising unemployment will drive lower consumer spending, and that will drive unemployment, and that will drive lower spending. And so on and so on.

But there are virtuous cycles, too. And right now it looks to me like the junk-bond market is in one. It shows that the markets are healing. That people are willing to take a little risk again. And paradoxically, in this case, the more risk people are willing to take, the less risk there is. The worst risk in a recession is that no one will take any risk. Think about it. It's true.

Now junk yields are down to about 18% from 22.5% a month ago. Today isn't the perfect moment to buy junk, as it was in mid-December. But it's still an amazing opportunity, in historical terms. If you agree with me that with worst of the credit crisis is over, then yields will keep falling in that virtuous cycle I talked about. I think there's still plenty of opportunity.