The Post Hoc Junk Bond Fallacy

CNBC correspondent, Bob Pisani (a noted eternal bull), provided some interesting data this morning. Mr. Pisani noted that pension funds have reduced their equity holdings from 60% in 2006 to 38% today. In that same time period endowments reduced their equity holdings from 48% to 33%. According to his sources, the reason is for the reallocation is aging baby-boomers. Much of the assets have been reallocated to fixed income. If this sounds familiar, it should. We have mentioned asset reallocation many times in this space. We believes that, as the population ages, the reallocation will increase. At some point, this reallocation will cease. After all, no one, not even baby-boomers, live forever. For now though, we expect to see more capital flowing into bonds and bond funds. Bond funds were also included in Mr. Pisani's report. He mentioned that the amount of money in high yield bond funds has risen to $212 billion from $102 billion in 2008. Mr. Pisani also stated that buying high yield bond funds is more akin to buying equities than buying bonds. He used ETF JNK as an example. For much of its existence JNK (created in December 2007) has tracked very closely with the Dow Jones Industrial Average and the S&P 500 (see following chart). Notice how JNK followed equities, that is, until 2012. Many investors have been sold a bill of goods that high yield bonds are not all that susceptible to interest rates and interest rate forecast and do well when the economy does well. What is (conveniently) left out of this theory is that, high yield companies need to refinance maturing debt and often desire to issue new debt in order to expand their businesses. If junk bonds typically follow equities, why did the disconnect between JNK and equities begin during the winter months of 2011 and 2012, when the economy appeared (to some) to be recovering more rapidly? An equity bull might opine that money was leaving high yield bonds and moving into stocks, but fund flow data debunks that theory. Let's look at the same chart, but with LQD (high grade bonds added). Lo and behold, it has been a high grade bond ETF, and not a high yield bond ETF which has tracked equities, Why has this been so? Contrary to what many high yield mutual fund wholesalers might tell you, high yield bonds are sensitive to higher rates. Although interest rates are not expected to skyrocket, they are unlikely to trend much lower. Couple that with the fact that the move to high yield debt by investors might be a bit overdone, and a leveling off of high yield bond prices, due to slackened demand, and the disconnect between JNK and equities is quite logical. Investors need to understand that much of the capital which flowed into junk bonds should not be there and would not be there if not for the very low interest rate environment. It appears as though many investors are taking their money out of junk and moving into assets which should be better able to ride out both the waves caused by higher rates or a recessionary storm cause by the upcoming Fiscal Cliff. We have stated for many months that we had been living in a golden age for junk bonds. All golden ages must come to an end. The bottom end of high yield has the potential to enter the dark ages, while some high grade bonds (and upper-tier high yield bonds) are experiencing a renaissance. A question which should be asked by investors and financial advisors alike is: "Which would I rather own, junk bonds or high-dividend common equities of strong, blue chip companies?" Many readers may expect Bond Squad to favor junk bonds. After all, we are a fixed-income-focused concern. However, we are also very candid and frank. We would rather own an un-notarized I.O.U. from T, PG, JNJ and similar corporations than senior bonds issued by Rite Aid, American General Finance or Office Depot. Tom Byrne tom@bond-squad.com. www.bond-squad.com www.mksense.blogspot.com 347-927-7823 Twitter: @Bond_Squad