Why You Should Be Selling Your Junk Right Now.
- Apr 15, 2005
- admin
- Investing
THE END OF THE BULL MARKET IN BONDS MEANS DANGER AHEAD
Warning, warning…
At the end of a bull market, optimism is at its peak.
And when optimism is at its peak, reason is at the trough.
Itís at this point that every person you know wants to get a
piece of the next hot IPO.
Anybody who remembers the roaring 90ís knows what Iím talking about.
In 1997 it was strong, truly innovative companies like Yahoo and
Ebay that went public.
By 2000 it was the copycats – guys trying to get paid IMITATING
market leaders like Yahoo and Ebay that were going public.
And investors wanted all they could get. Why?
Because your next-door neighbor got 3,000 shares of EBAY at the
IPO price.
And having watched them make a quick $400,000, add a wing to the
house and a cocky stride could be difficult even for the most
Bohemian of people.
Hence the point that you could tell when a bull market is coming
to an end by the ìqualityî of companies going public.
The worse the quality, the closer you are to a bear market.
And right now thatís whatís happening in the junk bond market.
Let me explain.
In 2002 newly issued junk bonds made up roughly 2 percent of
all corporate debt issued.
This year itís expected to jump to roughly 16 percent ñ almost
an all-time high.
That tells me that companies with shaky balance sheets ñ the
equivalent of weak dot-com companies – are rushing to borrow
as much money as they can while the getting is still good.
But thatís about to end. And end in a big way.
Why?
For a couple of reasons.
For starters it simply doesnít PAY to be invest in junk bonds
right now.
Thatís due to the fact that the spread between risky junk
bonds and safe US Treasuries is at a measly 3.6 percentage
points.
Why is the spread so important?
Because it shows the risk premium investors are getting for
investing in junk bonds.
And if youíre taking on too much risk and not getting paid
enough to do it, somethingís gotta give.
Hereís an example:
Letís say you could buy a risk-free, tax-free US Treasury
bond with a yield of 4 percent.
Compare that with the risky, TAXABLE yield of 7.6 percent you
get for junk bonds and there is a problem.
Why?
Because junk bonds rated below BBB default 29 percent of the
time within the first year of issuance.
Whatís even worse is that they default an astounding 48 percent
of the time within five years.
And assuming you hold your bonds for at least five years
you have to ask yourself the following question:
Is 3.6 percent ABOVE Treasuries enough for a risk of almost
50 percent default rate?
Not on your life.
But thatís only part of the problem.
The other part is that the FED is raising interest rates.
That means the price of money is becoming more expensive.
And when the price of money goes up, the price of bonds go down.
So do the price of stocks.
What does this mean to us as investors? Hereís the advice
I’m giving my Mom:
1. On the debt side, Iíd be selling all my junk bonds in a hurry.
2. On the equity side, Iíd be taking profits in any small-cap
stock that has had a good run.
3. Iíd also be combing my portfolio to make sure I didnít own any
ompanies that have a debt-to-equity ration higher than 30 percent.
Personally I donít mind taking calculated risk.
But history suggests that owning any of the above would be more
than a calculated risk ñ it would be more like shooting craps w
here the odds on favorite is a house win.
Remember, you are what you read.
— Dylan Jovine