A fortnight or six ago, I told you kids about the passive income source which are junk bonds. Skip the next paragraph if you’re already well aware of said asset class. If not, prepare to get your face educated RIGHT OFF.
Junk bonds are debt instruments issued by companies that are down on their luck. Individually, they’re pretty risky, but can also lead to some pretty exciting profits when you get the trade right. They’re much safer as a group, so I usually suggest y’all buy a junk bond ETF or a closed end fund.
I own the Dreyfus High Yield Strategies Fund (NYSE:DHF) because it uses leverage to really goose the yield from its portfolio of junk debt. It currently pays a dividend of 9.6%.
One thing I didn’t focus on when talking about junk bonds before was the ideal time to buy. If you’re buying the asset class as an income play, you shouldn’t really care about underlying price movements. As long as you’re happy with the yield, just let the price flap around like the Simpsons watching Japanese cartoons.
That was short-sighted. It always matters what you pay for an asset. Getting yield is nice. Getting a sweet capital gain along with an outsized yield is even nicer. It’s like an extra scoop of ice cream. Nobody says no.
It turns out there’s a really easy way to predict the return of junk bonds going forward. Seriously, it’s uncanny.
Junk bond return indicator
Here’s how it works. Junk bonds will always trade at a premium yield versus other bonds, because they’re riskier. Duh, right?
You’d also think this premium would remain relatively steady over time, with junk bond yields rising and falling with interest rates. This happens a lot of the time, but there are also issues that only impact the junk bond market individually.
One example today is the energy sector. A lot of energy bonds have entered junk status because oil remains under $50 per barrel. If the price of oil falls, the entire junk bond sector can get hit.
Junk bonds also will rise or fall depending on the general economic outlook. Even though the asset class tends to perform pretty well as a group, when the economy suffers, investors run away, convinced every junk bond is going to go to zero.
Like with any investment, the key to buying junk bonds successfully is to get in when they trade at a huge premium to safer bonds and get out when the gap narrows.
The St. Louis branch of the Federal Reserve keeps track of the spread. Let’s take a look at the last 10 years worth of numbers.
We’re obviously not going to see 2009 numbers anytime soon, but let’s focus on late-2011 and early-2016. Both times, the spread between safe bonds and junk debt peaked at about 9%. It was a good time to get in.
Looking at a long-term chart of NYSE:JNK, the largest junk bond ETF, confirms it.
If you would have bought in October, 2011, and sold in 2014, you’d be looking at a capital gain of at least 10%. Plus the nice yield. The capital gain had you bought in early 2016 would have been similar.
You’ll notice that while today probably isn’t a good time to buy junk bonds, the spread in 2007 was even lower. You can see what happened next. It works as a contrarian indicator as well.
Yes, it really is that simple
Sometimes, investing can be easy.
To ensure capital gains when buying junk bonds, buy when the spread approaches 10%. It worked in 2011 and 2016, and even would have worked out well in 2008, assuming you didn’t panic and sell when the spread went over 20%.
With the spread being so low today, I’d recommend against buying. Getting a decent yield is nice. Getting a decent yield with upside is better. Remember, capital gains matter too.