Sure, if you're well-heeled, you can buy into a short-selling hedge fund managed by the likes of Doug Kass, who was the subject of the interview in this week's Barron's ("Confessions of a Short Seller," May 19.)
After that, the pickings are pretty slim. At least in the late 1970s and early 1980s, you could feast on double-digit money-market fund yields that approached 20%. Or you could buy short-term or intermediate bonds with yields of 15% or more for quality corporates.
Early in this century, you could lock in 4% real, risk-free interest rates with Treasury Inflation Protected Securities. Tack on the inflation indexation of about 4% from the Consumer Price Index and you've got a huge risk-free return. Since then, however, 10-year TIPS yields have plummeted to about 1.4%, producing massive capital gains for perspicacious bulls on indexed bonds. Among them was Jeremy Grantham, the first name in GMO, as in Grantham Mayo van Otterloo, the highly regarded institutional money managers.
Or you could have bought the euro for less than a buck then. Just by holding the same currency that Germans, Italians or Spaniards have in their wallets Americans could have made about as much as investing in the Standard & Poor's 500.
And only a year ago, you could have stashed your cash in a garden-variety money-market fund or even some federally insured savings accounts and have earned 5% annually -- just as the equity and credit markets were about to cave in under the pressures of the credit crisis.
So what does that leave investors now? Stocks have bounced back more than 10% in what's probably a bear market rally since the rescue of Bear Stearns by the Federal Reserve and JPMorgan Chase on St. Patrick's Day Eve. And though Treasury yields have blipped up since then, 2.39% for a two-year note or 3.82% for a 10-year note isn't going to set any investor's heart aflutter.
Given the paucity of attractive alternatives available, junk bonds should be investigated, writes Paul Macrae Montgomery in his Universal Economics newsletter. High-yield corporates don't necessarily follow Treasuries but have equity characteristics. It's very difficult to model the behavior of junk bonds because their underlying fundamentals sometimes are mutually offsetting and other times mutually reinforcing.
At the moment, junk bonds offer interest yields comparable to the long-term total return of the equity market, 10% or more. Even so, Montgomery observes, "more money has been lost reaching for yield than at the point of a gun." Yield hogs more often than not lose more in price declines than they gain in income.
As a result, Montgomery ignores yield and watches prices of junk bonds, specifically high-yield, open-end no-load bond funds, which he uses to manage clients money. When the prices of those funds rise, he buys. When prices fall, he bails.
Prices have been in a steady uptrend in the past two months since the Bear Stearns bottom, Montgomery's work shows. Still, he points to some caveats.
First is a technical relating to some high-yield bond funds that use credit derivatives to give a synthetic exposure to the junk market. The more actively traded derivatives tend to jump around more day to day than real bonds. The more volatile funds with derivatives may provide more head fakes and opportunities for day traders.
More fundamentally, Montgomery points to research from long-time market guru Steve Leuthold that shows default rates on junk bonds have lagged behind the rise in their yields to a much greater extent than in previous cycles. It may be that defaults haven't caught up with the deterioration in the economy or the credit-repayment ability of some corporate borrowers that were afforded excessively generous terms at the tail end of the credit cycle.
In any case, junk bonds' yield premiums had risen into the "Extreme Fear" zone of about 190 basis points (1.9 percentage points) over Treasuries before retreating back into the high end of the normal range, according to Ned Davis Research data.
Junk bonds previous got into the Extreme Fear range in late 1990, with the collapse of Drexel Burnham Lambert and the previous credit-crunch recession, and in 2001 and late 2002, in the tech-telecom-terrorist recession and bear market. All those episodes proved to be major buying opportunities in junk bonds, which provided high yields and capital gains in the subsequent recoveries.
The Ned Davis charts cited by Montgomery show that, even when junk bonds' valuations are attractive, as in 2001, they can still fall and produce lousy returns in the short term. That's why Montgomery watches his junk funds closely day-to-day.
Junk bonds look good, according to Montgomery's indicators, which can change on a dime. To a less technically oriented and more fundamentally grounded investor, junk bond funds offer value, especially compared to a year ago, when yield spreads were near record lows.
Bottom line for the junk-bond market: it's cheap but could get cheaper. If so, it's a time to nibble.
