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.
Let’s say you’re the average value investor who doesn’t see a whole lot of value in today’s market. You’re doing some prudent things like selling a few stocks that you feel are overvalued, keeping in mind selling everything is a really dumb move.
Although yields aren’t very high today, you’d still like to get paid a little in exchange for keeping your money in your brokerage account. After all, they are lending out that excess cash. You should get to share in the spoils. At least a little.
Yeah, you could transfer the cash to one of the various online banks, but that takes effort, dammit. Besides, the whole point of keeping this cash on hand is to take advantage of opportunities. Transferring to and from other accounts takes time.
Here are a few different places you can park short-term cash without taking it out of your brokerage account.
High-yield savings ETF
Let’s talk a little about the most boring ETF in the history of mankind. Naturally, I love it. My favorite flavor is also vanilla and I prefer to visit countries without strong opinions about anything, namely Switzerland and Sweden. I’m also a big fan of oatmeal.
It’s the Purpose High Interest Savings ETF (TSX:PSA) and it’s the equivalent of keeping your brokerage cash in a high interest savings account. It’s a decent spot for Canadian investors to park their short-term cash.
As much as I joke about how boring the Purpose ETF is, it’s actually pretty useful.
Here’s what it does. The fine folks at Purpose take their capital and invest it into a number of high interest savings accounts. The yield on them is right around 1.1%. It then takes 0.1% as a management fee, leaving investors with a 1% yield.
That’s a little worse than what you’ll get on your own, but there’s a big advantage to using this ETF. It gives investors a way to earn a little interest without a) being subject to the price whims of bonds and b) having to transfer money out of their brokerage account. 1% isn’t much but it’s a hell of a lot better than 0%.
The price chart is the perfect example of the efficient market theorem. Let’s take a look.
Here’s what happens. Investors know this ETF pays about 50 cents per share each year, broken down into 12 months. Thus, each monthly payout works out to a tiny bit more than 4 cents. Each week a penny per share is earned but not paid out. This means the ETF is now worth $50.01, $50.02, etc as the month goes on. It peaks at slightly more than $50.04. Then it starts over the next month.
A couple of issues, however. The first is liquidity. Google Finance says the average daily volume is 8,879 shares. That’s probably sufficient for anyone who isn’t a baller, but you’ve still got to make sure you’re paying the correct price. Paying $50.01 versus $50 usually doesn’t matter. It matters with this ETF.
There’s also commissions to worry about. Questrade has free ETF trading, but most other online brokerages don’t. Say you’re using TD and paying $9.99 per trade. Here’s how the cost would break down if you bought 100 shares and held them for six months.
Purchase price: $5,000
Interest earned: $25
Commissions paid: $20
Total profit: $5
Annual yield: 0.2%
Not very exciting, is it? Even if you triple the amount of money invested, the total yield still isn’t very attractive.
Purchase price: $15,000
Interest earned: $75
Commissions paid: $20
Total profit: $55
Annual yield: 0.73%
Keep in mind that if you use a traditional bank’s online brokerage, you’ll have access to their GICs. CIBC currently offers a six-month GIC that yields 0.85%, but you’ll have to pay a penalty to get it out. It also has a flexible GIC that pays 0.5%.
RBC offers a cashable GIC that pays 0.7%, but it comes with a minimum purchase price of $20,000 for non-registered accounts. The minimum is much lower inside your RRSP.
TD offers a 100 day GIC that pays 0.4% annually if you invest $10,000 or less. The rate goes up to 0.68% if you’re putting in more than $100k.
And so on. Just keep in mind that you’ll have to have money invested with TD to get that TD offer, and so on. I use QTrade and Questrade, which don’t offer GICs. Sad!
Related: Oaken Financial offers great GIC rates, but there’s a catch.
Other short-term cash options
An underrated place to park short-term cash is using T-bills. These are short-term debt instruments issued by governments and banks that offer comparable rates to short-term GICs.
Here’s how a T-bill works. You’d buy it for $0.99 (and change) and then sell it at $1 in a couple of months. The spread between the two is your interest.
QTrade’s bond service lists 20 or so options, which all come due less than three months from now. There’s a Bank of Nova Scotia t-bill that can be bought for 99.79 cents and sold for $1 on May 25th. The yield is 0.21% for just under three months, which means this particular t-bill comes with an annual yield of approximately 0.9%. There’s plenty of liquidity in the T-bill market too, so it wouldn’t be hard to sell in a hurry. And brokerages don’t charge commissions for bonds, it’s reflected in the price.
You can also buy a short-term bond index. Canada’s largest is iShares DEX Short-Term Bond Index (TSX:XSB) which yields 2.3%. The problem with that is there is some price movement. The ETF is down 1.7% in the last year and 0.81% in the last six months. Not much, but it’s still something to consider.
The bottom line
It might not seem like much to put your cash to work in some of these short-term vehicles, but something is better than nothing. This isn’t something you should get overly excited about. Still, an extra 1% is better than a kick in the teeth. Unless you’re into that sort of thing.
Should I start with a junk in the trunk reference, or point out that the term junk is also a slang word for male genitalia? Decisions, decisions.
As I’ve explained before, y’all gotta get yourself some bonds. They serve a couple of purposes. First, they tend to go up when CRAZY TWEETING PSYCHOPATHS LIKE DONALD TRUMP make stocks crash. SMDH, he’s already ruining America.
Wait. I’m being told that didn’t happen. Well. That’s surprising.
When stocks crash, that’s usually a good buying opportunity. Since most people are fully invested (or at least should be, since opportunity costs are a very real thing), they don’t have a ready cash source available when it’s time to start buying. That’s where bonds come in. You sell them and buy equities.
There’s just one problem with bonds today. They don’t offer much in yield. Canada’s biggest bond ETF (the iShares bond universe index fund, ticker TSX:XBB) pays less than 3% annually. That’s not bad when compared to a GIC, but it’s not very exciting. I NEED A RUSH BABY YOU GUYS GOT ANY METH?
There are other bond sources that pay much higher yields. Let’s take a closer look at junk bonds, the perfect thing to sexy up your fixed income portfolio.
What are junk bonds?
Junk bonds sound bad, Nelson. Real bad. I don’t care for things that are bad.
Thanks for helping out, Italics Man.
Junk bonds (or high-yield bonds if you’re being paid by someone who peddles such things) are debt instruments issued by riskier companies. The bond risk hierarchy goes something like this:
- Mortgages and other things backed by the government
- Provincial/State governments
- High-quality corporate debt
- Medium-quality corporate debt
- Countries ran by dictators or Greece
- Terrible corporations
- Your friend Steve
When interest rates were higher, the spreads between the best risks and the worst risks was in the neighborhood of 5-20%. That spread has tightened somewhat. A government can get short-term money for 1%. Most junk bonds don’t pay any higher than 8%.
Junk bonds don’t really behave like regular bonds. Most bonds go up and down based on two factors — interest rates and the direction of stocks. Often these two things go hand in hand. So if stocks fall, that means rates will fall with them. Bonds will then go up. The opposite happens when stocks rise. Junk bonds do follow interest rates, but they also react alongside stocks. They’re much more sensitive to the overall health of the underlying company.
Look at it this way. Microsoft is one of the safest bets in the corporate bond world. It’s going to pay back its debt no matter what. Things are much dicier for a company like Teck Resources. It needs a halfways decent economy.
How to invest in junk bonds?
Let’s focus with the two easy ways, which are through ETFs or closed-end funds. You can also buy individual junk bonds, but if you could do that you’d probably be reading smarter stuff than this crap.
There are a metric assload of junk bond ETFs out there, all with their own unique spin on the world but with only the smallest of differences. Hey, just like personal finance blogs!
Oh, that’s gonna get him punched.
The biggest junk bond ETF is the SPDR Barclays Capital High Yield Bond ETF, which has a very appropriate ticker of JNK on the New York Stock Exchange. It holds 811 different bonds that have an average yield to maturity of around four years. It pays out a dividend of 6.1%.
The junk bond world in Canada is much smaller than in the U.S., so we’re pretty much stuck investing there. But there are quasi-Canadian ETFs that at least trade on the Toronto Stock Exchange. BMO has a U.S. junk bond ETF that’s hedged to Canadian Dollars (TSX:ZHY), that pays 6.1% and has an average of about four years maturity left. But it only holds 463 different bonds like a chump and/or chumpette.
I don’t own any of these ETFs. Instead, I use a closed-end fund to get exposure to the sector. I even pay a management fee of (gasp!!!) greater than 1% to do so.
I own the Dreyfus High Yield Strategies Fund (NYSE:DHF) which uses leverage to enhance junk bond returns. In a nutshell it takes a dollar, borrows an additional thirty cents, and invests the $1.30 in a couple hundred junk bonds. Because it can borrow at good rates, this gooses my yield in exchange for a little more volatility. I’m quite okay with this trade-off.
My Dreyfus closed-end fund yields 9.8% versus 6.1%, which is what a comparable ETF pays. If we’re looking for income, that’s good.
I’ve held that fund for close to a decade now. It has cut the payout a few times, but only because bond rates went down. Individually, junk bonds are risky. A group of two hundred of them aren’t. The risk is in interest rates, not so much with companies not paying.
If you’re interested in the whole leveraged bond market, there are dozens of such closed-end funds out there. I should really do a blog post on some of them.
Should you do it?
Yes, you should add junk bonds to your portfolio. They’re volatile, but they are also a pretty outstanding income source.
In the decade I’ve owned the asset class, I’ve basically broke even on the price of my fund and collected a dividend of approximately 10%. I’d call that a decent result.
There are just a couple of things to remember. First, consider them equities rather than bonds. They won’t be an ocean of tranquility when markets are falling. And don’t freak out about price movements. I’ve always considered the asset class a cash flow game. It’s the perfect investment to tuck away and forget about for a while, especially if you own it in a fund.
Bonds are more boring than your Grandpa’s stories about the 1950s. Yes Grandpa, we know you didn’t have TV back then. No, we don’t care.
But guys like me have to tell you do own them in your portfolio. We do this because we don’t want to get sued, and to encourage risk-adverse investors to smooth out their returns by including an asset class which just about always does well as stocks implode, and vice versa. OOH LATIN I’M FANCY.
I’ve even gone as far as arguing that investors should sell their bonds when the market tanks, freeing up cash to buy undervalued stocks and temporary tattoos, for some reason. Eight year olds don’t even think those are cool anymore. No. I don’t care if yours says Spiderman. Put it away, dammit.
There’s just one problem. In a world where interest rates are lower than Bernie Sanders’s chances for the White House (BOOM STILL GOT IT), nobody wants to earn 2% interest. So they migrate to other bond-like securities like REITs or preferred shares. These give higher yields, but usually come with increased interest rate risk.
Check out how much more volatile preferred shares and REITs were compared to bonds over the last five years.
That boring blue line is the thing you want to own during turbulent markets. Those other lines are pretty much the definition of turbulent.
(Goes to dictionary.com, adds “squiggly red and sorta orange lines” to definition of turbulent, gets kicked off the internet forever)
But what if there was a way you could have your cake and eat it too? Is there really a way to get interest rates of 5-10% without taking on big price risk? And did you immediately stop reading and start daydreaming about cake once you saw that word?
Perhaps there is. Let’s take a closer look at leveraged bond funds, a unique product that uses debt to goose returns.
What’s a leveraged bond fund?
Let’s start at the beginning. What the hell’s a leveraged bond fund?
It’s simple. A normal bond fund buys bonds. These bonds pay interest to the fund, which passes it onto you, the investor. You then show your accountant a little cleavage in the hopes that he’ll get you out of paying taxes on this interest.
A leveraged bond fund is basically a bond fund on steroids. The bond fund uses debt to buy even more bonds. The interest on the bonds is more than the interest on the debt, which increases the yield on the whole portfolio.
Remember when I told you guys to how to borrow to buy REITs, letting the dividends pay the interest and keeping the remainder? It’s pretty much like that, but with bonds.
Let’s look at a couple of real life products as examples, starting with the Dreyfuss High Yield Strategies Fund (great band name, amirite?), which trades under the ticker symbol DHF on the NYSE.
This is a fund I’ve owned for years, btw.
It works like this. The fund invests in high yield bonds, investing in companies like Crysler, Rite Aid, Ally Financial, and names like that. These are household names, but they’re definitely not blue chip stocks. On their own, these bonds probably yield in the 5-8% range, depending on the crapitude of the issuer.
In total, the fund owns about 200 different bonds, diversified among pretty much every sector. Approximately 5% of the portfolio is in energy, which isn’t an alarming percentage.
The fund then borrows an additional 33% of its net asset value and puts that cash into more bonds. So it has approximately $260 million of its own capital and $90 million of borrowed money. The interest rate on the debt is quite low, under 2%. Oh, and it has a management fee of more than 1%.
The leverage really adds to the return. Shares pay out $0.0290 each per month, which works out to a yield of approximately 11.2%. That’s succulent, especially in a low interest rate world.
The issue with this leveraged bond fund is the volatility. It already invests in the riskiest bonds, and then it adds leverage to the mix. That combination means you’re looking at equity-type of returns for something that’s supposed to add stability to your portfolio.
So much for that idea, at least from a bond perspective.
But what if we used assets a little more stable?
Leveraging municipal bonds
Dreyfus has a very similar leveraged bond fund that invests in municipal bonds instead of junk, which trades under the ticker symbol DMF on the NYSE. How did it perform?
Pretty well, actually. Over the last five years it gained 11.3% while the junk bond fund lost 34%. Including dividends, we’re looking at a return of approximately 7-8% a year for the muni bond fund.
The current yield isn’t nearly as exciting as the other Dreyfus product, coming in at about 5.5%. That’s half as much as the leveraged junk bond fund, but it’s still a hell of a lot better than you can get investing in government bonds or GICs.
It’s hard to draw conclusions from just two data points, but screw it. I’m going to do it anyway. It’s pretty clear that if you’re going to use a strategy like this, you want to own quality bonds. There’s a reason why the munis did better than the high yield stuff. It’s because munis did better in general.
And for Canadian investors, it’s tough to find Canadian versions of these closed end funds. There are only approximately 150 total Canadian closed end funds, with the majority not using any sort of leveraged bonds strategy. I could only find a couple while researching this post, and they’re so tiny we could probably all get together and buy them outright.
One other note of caution when buying closed end funds. Most trade at a discount of between 5% and 15% of their net asset value. So don’t buy an IPO if it comes out unless you like lighting your money on fire. Wait a few weeks for the discount to be established and then buy.
And if you come across any kind of closed end fund that trades at a premium, run away. Back when I wrote for Seeking Alpha, I wrote about a closed end fund that traded at a ~50% premium to its net asset value. In the meantime, it has dipped below a 10% premium, before settling in at a an average premium of 30% so far this year. Investors who bought at the big premium have lost money.
Anyhoo, let’s wrap things up. Leveraged bond funds can be used as a bond substitute, assuming you’re willing to stomach a lot more volatility. But you should probably just stick with bonds. The only real advantage to one of these funds is the increased yield.
Bonds are the Rodney Dangerfield of investments. They get no respect, and apparently they’re also Mr. Burns’s son.
It’s pretty obvious why many investors want nothing to do with bonds in the year 2016 (WHERE ARE THE FLYING CARS? HUH?). The interest rate offered on high-quality bonds is less exciting than a date with your sister. GIC yields are even worse. And even though the TSX finished 2015 in negative territory, stock pickers are still comforted by the fact that it’s easy to build a dividend portfolio that yields more than anything but the riskiest bond fund. Add in dividend growth and solid results from U.S. stocks when converted back to local currency, and it probably wasn’t a bad year for the folks who insist on being 100% into stocks.
Related: The surprising reason why you should own bonds. OOOH TEASE
An argument I often hear from folks who are fully invested in stocks goes something like this. I don’t need no stinking bonds, they say, because I’ll be collecting CPP when I retire. That, combined with any pensions I might have, are the perfect bond substitute.
There are lots of similarities between bonds and CPP. Both offer predictable payments. Both aren’t known for growing the distributions they pay much, if at all. And both are far more stable than stocks. They’re even more stable than a well diversified portfolio of dividend growth stocks. Even if a company goes bankrupt, usually some remnant of the pension remains.
These points are true. But the folks who think CPP is a bond substitute are missing a couple of important points.
What about the capital?
The big issue with pensions and CPP is you can’t access the cash. With certain pensions you might be able to get a lump sum payment, but it’s generally not a good idea. The whole point of having a pension is you sit back, relax, and money falls out of the sky each month.
Meanwhile, if you buy a whole portfolio of bonds, GICs, or whatever fixed-income substitute you want to use, you have access to that cash at any time. You might have to pay a bit of a penalty to get out, but it shouldn’t take much longer than a day to get your money. All of it.
The other thing about pensions is at the end of the day, you’re getting interest plus some of your money back. If you live longer than expected, it’s okay. Your buddy Tim probably keeled over before he was expected. Thank him for his share when you visit his grave.
Thus, I think the whole comparison is off. Pensions aren’t a bond substitute. They’re annuity substitutes. There are a lot of similarities between annuities and bonds, but they’re not the same products. Not by a long shot.
The real reason bonds are important
Most investors gloss over the real reason why bonds are a big deal. They level out returns during periods of uncertainty.
I’ve argued before for a system that increases an investor’s bond allocation to between 80 and 100% between the ages of 60 and 65, especially if the market is hitting new highs. The argument is that you want to lock in gains at that point and ensure there’s going to be enough left over for spoiling the grandkids and buying pants that go up to your armpits. Once you hit retirement age, you start to increase the risk tolerance again, eventually ending up at a more traditional bond/stock mix.
The whole reason why bonds are important to a portfolio is they do well during periods when stock markets don’t. As a perfect example, take a look at bond returns compared to TSX Composite returns for the year of 2015.
The total return on that bond ETF would have approached 4%. That ain’t bad when compared to the TSX Composite. A 50/50 split between bonds and stocks wouldn’t have lost much more than 5% after considering dividends.
I’m continuing to buy Canadian stocks at these levels because I can find good value out there. I’m even selling off some bonds and preferred shares to do so. Bonds also serve as a terrific capital base for folks who are fully invested.
Back in 2014, I couldn’t find much to invest in. So I threw money into one-year GICs and promo accounts from a certain orange-colored bank. I averaged around a 2% return, which ain’t very sexy.
But I also protected my capital. And now that I’m finding value in the Canadian market, I’m putting it to work again. I’m buying the stocks I picked for the stock picking contest, plus some other, more conservative choices. I have this capital available because I kept 20% of my money in fixed income when times were good. Somebody 100% invested in stocks back in 2014 has very little capital available to take advantage of a downturn.
If you allocate CPP as your bond substitute, you won’t have that money available to invest when there are opportunities out there. You’re stuck taking all the risk of the stock market. If you’re old enough to be collecting CPP in the first place, that’s a bad idea.
Look at CPP as an annuity, not as bonds. If you do, you’ll likely see the pros of having a healthy bond component when you retire. Remember, retirement isn’t about ending up with the most cash. It’s about protecting the cash you already have.