High-yield investments require some research

By DAVID MOON, Moon Capital Management, LLC
March 6, 2011

When I started in the investment business in the mid-1980s, ten percent was a benchmark figure for interest rates, especially for individuals. If you could get a mortgage under ten percent, you considered it a bargain. No one wanted to invest their money at less than ten percent, even in Treasury securities or bank CDs.

Who could blame anyone? In 1982 short-term interest rates were in the mid-to-high teens.

Today the yield on high-yield grade bonds is below seven percent. “High yield” is a nice euphemism for “junk.”

Based on even recent history, seven percent is the type of yield associated with highly rated, investment grade bonds. The average yield on high yield bonds, however, is currently 7.83 percent.

Not only is the absolute level of rates on low-grade bonds low, the yield difference between junk and investment bonds is only 4.4 percentage points, about 33 percent below its historic average.

In an effort to chase yields, investors are ignoring, or at least severely discounting, the risk associated with junk bonds.

In January, the default rate on junk bonds was three percent, meaning that a yield of seven percent would net only four percent, after adjusting for capital losses.

Four percent hardly seems adequate for the risk associated with these types of bonds, especially if you consider the added risk of potential rising interest rates in the coming years.

Who should be interested in this?

Anyone who owns a mutual fund with the term “high yield,” “enhanced yield,” “yield plus” or anything similar in its name should do a little research on the fund. If the yield on your bond fund is more than five percent, you better figure out why.

Perhaps your fund owns extremely long-term bonds. That is a separate, but very real, different sort of risk. (See my April 25, 2010 column for a discussion of this risk.) Or, unbeknownst to you, the fund might own junk bonds.

Another technique that closed-end bond fund managers use to enhance their yield is to borrow money on behalf of the fund’s shareholders, thereby being able to leverage their assets by up to 50 percent. This technique might allow a junk bond fund manager to increase his stated yield from seven percent to over ten percent.

This is fine, as long as the bonds don’t default, bond prices don’t decline, interest rates don’t increase or the cost of the money they borrow doesn’t increase. The leverage that works to an investor’s benefit when all is well does the exact opposite in a declining market.

Ancient Greek mathematician Archimedes said “give me a lever long enough and a fulcrum on which to place it and I will move the world.”

Financial leverage works the same way. Anything that happens on one end is magnified at the other end.

If you consider the bond or bond-fund portion of your portfolio as the safe, risk-free part of your assets, make sure you know what you own.

David Moon is president of Moon Capital Management, a Knoxville-based investment management firm. This article originally appeared in the News Sentinel (Knoxville, TN).

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