Junk Bonds Not Necessarily Junk

“It happens that certain material appears in the dream-content which cannot be subsequently recognized, in the waking state, as being part of one’s knowledge and experience.” – Sigmund Freud, The Interpretation of Dreams

Diamonds should no longer be a girl’s best friend. I’d exchange rocks, which yield zilch, for BB debentures yielding 5% or more. Basic to the valuation structure for everything in the world is the “cost of carry.” I remember paying 7.5% for deal money in the eighties. Today I finance high-yield investments for 1% or next to nothing.

Calling a bond junk ain’t descriptive enough. Five-year Treasuries now yield 25 basis points, down from 1.4% beginning of year. The spread between BB debentures with five-year duration is at 5%. Anyone owning five-year Treasuries should switch some capital herein.

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My experience with junk goes far back, before Mike Milken, late fifties. My brother, George was a major dealer in real junk. Dealers were tied in with teletype machines, but nobody discussed junk. It was mainly about spare parts.

If you wanted a rear bumper for a 1962-model Cadillac sedan, you called the local junk dealer. If he didn’t inventory it, he’d get on his teletype and find one for you, somewhere in the country. Like trading high-yield paper, this was a spread business. After 40 years, George found his junkyard situated in the heart of Chico, California. Unplanned, George found himself in the real estate business. Junk became a sideline.

Shouldn’t we retire the “junk bond” sobriquet for high-yielding debentures? Despite dire warnings by Street pundits that this paper would succumb in the Covid-19 environment of deep recession, nothing bad has happened. Actually, my industrial pets thrive, hardly wobbling even in the darkest days of fear, past March.

If you want to know what’s junk, take a look at interest coverage for municipal bonds. It’s non-existent for many states and cities, now wards of White House largesse. Sans massive injections of federal liquidity they’d succumb. Soaking the rich doesn’t work, either. We’ll move to tax-free states like Florida.

The preferred stock sector yields between 5% and 6%, too, but mainly financials. Banks and insurance underwriters use preferreds as a layer in their balance-sheet construct. Regulators lump outstanding preferreds as part of equity, thereby allowing banks more debt leverage.

Avoid preferred stock issued by banks. Almost all this outstanding paper is callable so there’s no upside on a $25 stock. That’s where they trade unless fundamentals for the parent deteriorate markedly. In the financial meltdown of 2008 – 2009, Bank of America’s BAC $25 preferred traded down to $5, adumbrating prospective bankruptcy.

Nobody talks today about Citigroup’s C  reverse split in 2009, to move its stock back into the teens from low-single digits. Chesapeake Energy CHK recently indulged in a reverse split, but months later, crumpled into bankruptcy.

There was no Warren Buffett ready to bailout Chesapeake. But, darkest days of 2009, Warren’s investment banking prowess came into play. He threw Bank of America a lifeline of several billion and took back warrants that ended up worth billions. I bought Bank of America’s preferred at five bucks. Management didn’t offer me any warrants to do so.

Today, our BB credits outside the energy sector are doing just fine. Ebitda coverage is improving. Many trade at $110 or higher. If you’re not up 5% in high yields, something’s wrong. In the tech bubble of 2000 – 2001, most internet stocks declined by 60% or more, but few defaulted on their bonds among bigger-capitalization houses.

Professional bond analysts, particularly in high yields, confine themselves to analyzing point spreads between various classes of bonds as to quality and maturity duration. For example, the current spread between 10-year Treasuries yielding 60 basis points and BB corporates yielding over 5% is historically enormous. Polite investors pass on high-yielding corporates. Fear in our Covid-19 world is pervasive.

I’d term many high-yield players as a bunch of cowards who overreact during the business cycle. When U.S. real GDP plunges to zero or below, even the spreads between BAA bonds and U.S. Treasuries can widen from 150 basis points to 350. In the 2008 – 2009 meltdown the spread spiked to over 550 basis points from its normalized trendline of 150 basis points.

With 10-year Treasuries yielding 60 basis points, currently, the spread relative to BB paper approximates 440 basis points. So high-yield players stick agnostic on business-cycle recovery near at hand. Conversely, stock market operators since late March have fully discounted economic recovery, hopefully around the corner. How else explain our market selling near 20 times normalized earnings?

My conclusion is only prolonged recession impacts our so-called junk bonds. Consider, yields spiraled down relative to five-year Treasuries from 900 basis points to 300 basis points. The time period approximated three years, 2012 to 2015. Such downward volatility surprised me in its compacted intensity. It convinced me that buying into such extreme-downside volatility is the contrary course to follow.

Then, I looked at my chart on oil futures during this volatile period of 2008 – 2014. Financial meltdown, 2008 – 2009, oil futures followed the same downside trajectory as bank stocks, from $140 to $30 a barrel in 2009, comparably lethal. It reinforced my point of view that the spread between BB debentures and 5 and 10 year-Treasuries favors BB paper, both as an absolute yield over 5% and a comfortable spread, historically speaking with Treasuries.

We may see zero to negative yields not just on money-market paper but in Treasuries stretching out to five years. If so, my high-yield debentures with average duration of five years turn golden. Conversely, anyone investing in Treasuries today not only receives a next-to-nothing yield, but probably faces more downside risk than in BB paper.

The history in 10-year Treasury yields going back 60 years shows a trendline approximating 5%. Only the financial market’s meltdown over 2008 – 2009 finally took yields down convincingly below 5%. Now we’re flirting with a zero rate of return.

I am arbitraging my cost of borrowing against 5% yielders. Taking quality risk rather than duration risk is my preference. After all, our markets – equities, commodities and bonds trace a volatile history going back to early-postwar years.

Mike Milken in the sixties was characterized by financial journalists as the “Junk Bond King.” But, this was totally inaccurate. Mike was first an investment banker who thirsted to do deals. Anti-establishment operators who concocted takeovers – Nelson Peltz, Meshulam Riklis, Larry Tisch, Carl Icahn, Ron Perelman, even Rupert Murdoch came to Mike for deal financing, John Kluge, too.

Establishment investment bankers didn’t finance “hostiles” and neither did establishment banks like JPMorgan JPM . Mike, through Drexel Burnham, raised the capital for them, selling high-yield paper to his clients and the public.

Ironically, Drexel Burnham was submerged when the cost of carry on its high-yield bond inventory exceeded its yield. Today, the cost of carry is minimal, under 1%. That’s why I’m comfortable with so-called junk.

Sosnoff and / or his managed accounts own Citigroup bonds.


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