A Bearish Bet on Junk Bonds

09/02/2005 12:00 am EST


Marilyn Cohen

President & CEO, Envision Capital Management, Inc.

"There's a new way to bet on a decline in the high-yield market," explains leading bond expert Marilyn Cohen. "And it's a good bet, as junk is way overpriced." Here, the president of Envision Capital and Forbes columnist explains this new vehicle.

"Remember West Side Story? Just as they say in the musical, ‘There's a rumble coming.’ The Sharks and the Jets in this case are junk bond bears and bulls. Retail investors have been exiting junk mutual funds (so far this year removing $7.93 billion, or 6% of the funds' assets, according to AMG Data Services), but hedge funds have kept buying junk, more than offsetting the mutual fund outflow. For once the retail folks are the smart ones.

I have been warning for some time that high-yield bonds are not worth the risk. Unfortunately, if you heeded my warning then, you have left money on the table thus far in 2005. The high-yield market has gone from overvalued to extremely overvalued. But the hedge funds won't continue their merry chase of junk prices forever. Junk is badly overpriced and overdue for a fall. The spread between a speculative-grade junk bond, one rated B2, and Treasuries is just 3.25 percentage points. That's not a lot of compensation for the risk of owning junk.

"The cumulative default rate over ten years for this grade of bond is 44.5%, according to Moody's. To be sure, you will be collecting a yield for the remaining 55.5% on a hypothetical portfolio over the ten years, but that would scarcely make you whole. If the long-running recovery stumbles, defaults will be worse than you see in these historical averages. In the late 1990s, even before the recession, defaults began increasing.

"It used to be that the only way to deal with an overpriced junk market was to get out. Now you can do better than that. You can buy a fund that, in effect, has a short position in junk bonds. That fund is the open-end, no-load Access Flex Bear High Yield Fund (AFBIX), which is managed by ProFund Advisors. The opportunity doesn't come cheap. The minimum purchase is $15,000, and fees are a bit high at 1.45% of assets annually.

"The fund does not generally short junk bonds, nor does it do any fundamental research. Instead, it seeks inverse exposure to the high-yield market through a creature called the credit default swap (CDS). This is a derivative for institutional players, a form of insurance against defaults. When junk prices rise (and yields drop), CDS prices fall because high-yield bonds seem less likely to default. When junk prices dip, CDS issues appreciate.

"Access Flex Bear buys these CDS instruments for a basket of 100 junk bonds. If defaults rise, high-yield prices will erode, spreads will widen between junk and Treasuries, and the value of the Access Flex Bear fund will climb. Since junk is still doing well, the fund is down 4% from its late-April launch. While the ProFund family has $7 billion in assets, the fledgling Access Flex Bear fund is a peanut, with $30 million. Still, it is growing fast, with $1 million per day in new money. The long-needed ability to short high-yield is certain to catch on quickly.

"The Access Flex Bear High Yield Fund enables you to hedge your traditional high-yield fund during a market descent or just outright bet on a decline in junk bond prices and a rise in their default rate. While buying and holding is usually a good strategy, don't hang on to this fund; use it only when you think junk is overvalued and ready for a correction."

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