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Who Cares if There's a High-Yield Bond Bubble?

March 13th, 2013

by Gary Halbert

of Halbert Wealth Management

IN THIS ISSUE:

1. Investors Are Pouring Money into High-Yield Bonds

2. An Expert’s Outlook for High-Yield Bonds

3. Slow and Steady Wins the Race

4. The Columbus High-Yield Bond Trading Strategy

5. Past Performance Evaluation

6. Conclusions – Time to Make a Decision

Introduction

High-yield bonds, or “junk bonds” as they are widely known, have received a lot of attention in recent months. Is there a high-yield bond bubble? Certainly a ton of new money has gone into high-yield bond funds over the last few years. Millions of Americans who would have never considered high-yield bonds have bought in due to near zero returns on traditional savings vehicles.

So, are high-yield prices at the top and destined to begin a downward plunge? Lots of people seem to think so, while others do not. Whichever side is correct, the bull market in high-yield bonds is getting long in the tooth, and investors who jumped onboard in the last year or so probably have no idea how much risk they are taking. We’ll talk about all of that today.

We all know that interest rates will rise at some point, perhaps significantly. Yields on 30-year Treasury bonds have already jumped 32% since last summer when Isounded the alarm. While high-yield bond prices are not as affected by rising interest rates, we may be seeing the end of this multi-year bull market.

For those of you inlong-only high-yield bond funds (and almost all of them are long-only), I strongly encourage you to pay special attention to the discussion that follows today. I am going to introduce you to a very successful high-yield bond money manager who has a 10-year track record of identifying when it’s time to leave the party and head for the safety of cash. And mark my word, there will be a time to leave the high-yield bond party.

Today, I’m featuring Sojourn Financial Strategies, LLC and its co-founder, Steven D. Landis, CFP®. In fact, Steve contributed to today’s letter so you can read his latest views on the high-yield bond market. Steve does an excellent job of explaining the opportunities available in high-yield bonds, and whether or not there’s a high-yield bond bubble in the making.

There are few investments that I think just about everyone should own, but Sojourn’s Columbus High-Yield Bond Program is certainly one of them. I consider them to be a “core holding” for a wide variety of investors seeking consistent returns and principal protection. CHYB has produced annualized returns of over 8% for over a decade and has largely side-stepped two serious bear markets in high-yield bonds. (As always, past performance is not necessarily indicative of future results.)

For anyone currently in high-yield bonds, or thinking about buying them, you need to read what follows very carefully.

Let’s begin with Steve Landis’s latest thinking on how to invest in high-yield bonds now that interest rates are near their historical lows. Steve is the founder and owner of Sojourn Financial Strategies, LLC and is the portfolio managers for its Columbus High-Yield Bond Program (CHYB) noted above.

QUOTE:

How to Invest in High-Yield Bonds in Today’s Low-Interest Environment

by Steven D. Landis, CFP®

High-yield bonds have been around for longer than most of us can remember. In this article, I will use the terms high-yield bonds, junk bonds, and “junks” interchangeably. These terms apply to loans that are made to higher risk corporate borrowers of money. The two terms used to describe these bonds, “high-yield” and “junk,” come from two features of the bonds: 1) High-yield refers to the increased interest rate that accompanies the bonds; and 2) Junk refers to the lower quality of the bond.

Interest in high-yield bonds has soared in recent years as investors have searched for higher returns. Today, the high-yield bond market is estimated to be in the $1.6 trillion range. Its explosive growth is the result of two factors: 1) more companies needing capital at attractive rates; and 2) investors seeking yield in light of record low returns on other types of bonds.

Why Invest in High-Yield Bonds?

The short answer to this question is that high-yield bonds provide an opportunity for both yield and capital gains. Unlike normal bonds that are greatly influenced by fluctuations in interest rates, junk bonds are less affected by rising rates. This is because junks generally have higher interest rates and have, generally, shorter maturities. In fact, junk bonds are affected more by overall economic changes (expansion or contraction) than changes (increase or decrease) in prevailing interest rates. This is because the quality of a junk bond is most affected by the strength of the company issuing the bond.

If a company’s profitability increases (since the issuance date of the bond), the quality of its bonds is likely to increase, leading to an increase in the price of the bond. For an investor in a junk bond, this is an almost-perfect scenario: One in which a junk bond with a high interest rate becomes a quality bond with a high interest rate (this being the result of the formerly high risk borrower becoming a low risk borrower).

Risks of Investing in High-Yield Bonds

A fact of life is that consumers with low credit scores must pay higher interest rates when they borrow money (ala “sub-prime” borrowing). This higher interest rate compensates the lender for the increased chance of the borrower defaulting on the loan. Likewise, corporate borrowers with a lower credit rating have an increased probability of defaulting on their loans and pay lenders accordingly.

Those who loan money to these corporate borrowers demand to be compensated for the extra risk they take in making these loans. Should a default occur, the bondholders stand in line with all the other creditors of the company, hoping to get back some portion of their money. The lower the quality of the bond, the less chance there will be assets that can be used to pay back creditors. The increased interest rate compensates the lender, at least in part, for this additional risk. The result is that those entities that lend money to higher risk borrowers, via junk bond offerings, receive a higher interest rate than if they had been lending money to higher quality (lower risk) borrowers.

An additional risk of junk bonds is their lack of liquidity. Liquidity refers to the ease of trading the instrument in the marketplace. I often refer to liquidity as “how quickly one can convert an asset to cash.” Junk bonds are not traded as freely as, say, government bonds. Thus, the liquidity of high-yields is sometimes significantly lower than that of high quality debt, which leads to higher costs of trading and selling at one’s desired price. All of these factors combined result in the higher interest rate that is attached to junks.

One way to deal with these disadvantages is to invest through actively managed high-yield bond mutual funds where an experienced fund manager evaluates the creditworthiness of each issuer. Plus, mutual funds invest in a large number of bonds from different issuers, providing instant diversification. As for liquidity, mutual funds are among the most liquid investments around. I’ll discuss more about this later on.

Is There a High-Yield Bond Bubble?

There’s no doubt that historically low interest rates have driven many income investors to high-yield bonds. This influx of money into that segment of the bond market has driven prices up and yields down (though rates are still attractive). I suspect that there are many investors who have bought high-yield bonds without any thought about the increased default risk. They are merely chasing returns.

But is there a high-yield bond bubble? First, we need to define just what an asset bubble is. As a general rule, a bubble exists in the price of an asset when there is speculative buying of the asset without regard to the underlying fundamentals. Think tech stocks in the late 1990s that were snapped up by investors even though the companies had little revenue and no profits.

While we have seen a major capital inflow into high-yield bond mutual funds and ETFs, I don’t think they are in bubble territory. A lot of the high-yield buying today is focused on yield since most other classes of bonds have low coupon rates. However, if prices rise too far, the yield won’t justify the investment and I think the money flow will slow down.

This is not to say that high-yield bonds can’t become an asset bubble, and that’s why a tactical approach to high-yield bond fund investing is so important at this juncture.

An Active Approach to High-Yield Bonds

As much as we really like investing in high-yield bond funds, they have onemajor flaw. That flaw is that there are times in which high yield bonds (and mutual funds investing in them) will get absolutely annihilated in a bear market. The years 2007 and 2008 are the most recent examples of this. In 2008, the majority of high-yield bond mutual funds lost more than 20% of their value. Worse still were those funds that lost more than 50% of their value!

Risk-averse investors may find themselves asking: “Is there a way to invest in high-yield bond funds without the risk of losing money in a down market?” Fortunately, the answer is, “Yes, there is.” My Columbus High-Yield Bond Program (CHYB) uses active money management strategies that seek to be invested in high-yield bond funds when they are gaining in price and sell before prices go down too much.

If successful, then you would be able to make more profit while taking less risk. By reducing the losses during time periods in which high-yield bonds are losing money (1998-2002 and 2007-2008) one can dramatically improve the potential for long-term profits.

It works like this. About 10 years ago, I developed a system that seeks to identify the direction of high-yield bond price trends. In rising price markets, my system first confirms the upward trend, and then invests in high-yield bonds and similar mutual funds. When prices start to fall, my system does the opposite and sells after confirming the downward trend.

Thus, my system doesn’t try to predict highs and lows, but rather identify major up and down trends while ignoring short-term “noise.” This means that my strategy may miss some of the early gains in an uptrend and lose a bit on downward trends. Overall, the goal is to participate in most of bull market moves while avoiding the majority of bear market losses.

Is the Party Over for 2013?

Before Gary gets into the nuts and bolts of my CHYB Program, let’s look at the prospects of the high-yield bond market over the rest of this year. Investors often ask my opinion of the high-yield bond market and are quite surprised when I say, “ It doesn’t matter.” They are surprised because they are coming from a standpoint of buying and holding bonds and bond funds, and I am coming from an active management standpoint that seeks to get out of the market when prices are trending down, something buy-and-hold managers and investors just won’t do.

Before the last couple of years, I would have told you that it would be extremely rare for interest rates to stay at historic lows for an extended period of time. But now we know that the Fed can and will print money to keep long-term interest rates down. The current demand for higher yield may reach a point where high-yield bond prices stagnate, but even then investors will continue to reap profits in the form of high interest income being generated by the bonds.

The only way that I can see a threat of significant loss is if you are a buy-and-hold investor in high-yield bonds. The investor who uses a skilled, active advisor/manager has a significantly greater chance of avoiding losses during a down market, while a passive investor will be counseled to “just ride it out.”

In summary, I contend that high-yield bond mutual funds can be an extremely attractive way to invest, though subject to potentially substantial losses during falling markets. Furthermore, I believe that investing in high-yield bond mutual funds can be an even more attractive method of investing, if managed under the guidance, direction, and oversight of an experienced and skilled Investment Advisor.

Steven D. Landis, CFP®

Sojourn Financial Strategies, LLC

END QUOTE

Slow and Steady Wins the Race -

The Columbus High-Yield Bond Program

As Steve made clear in his discussion above, active management of high-yield bond mutual funds can potentially allow investors to participate in both capital gains and coupon returns, while also moving to the sidelines during times of downward price pressure. This ability to move to cash in downward trending markets is very important, especially considering the aggressive nature of high-yield bond investments.

As I noted earlier, there are only a few investments that I think just about everyone should own, but Sojourn’s Columbus High-Yield Bond Program (CHYB) is certainly one of them. I consider it to be a “core holding” for investors who seek steady returns while also minimizing losses.

The Columbus High-Yield Bond Investment Strategy

So how has Steve found an antidote to the risks inherent in high-yield bonds? The answer is that Steve employs a proprietary trading model that is a quantitative approach to determine the high-yield bond market’s potential future movements. However, Steve goes one step further by analyzing the technical indicators unique to each of the high-yield bond mutual funds he uses.

Steve prefers using traditional actively managed high-yield bond mutual funds. Doing this allows him to combine his tactical management expertise with the bond selection expertise of the mutual fund manager. Plus, traditional high-yield bond funds typically pay a higher “coupon” rate of return than specialized index funds.

Since each mutual fund under consideration generates its own “buy” or “sell” signals, accounts may have anywhere from one to four positions at any given time. When no fund appears attractive, the strategy will remain in the safety of a money market account.

The CHYB trading model does not use leveraged funds, nor does it use specialized inverse funds that provide a net “short” exposure to the high-yield bond market. However, Steve may use such inverse funds as a hedge under certain conditions.

While Sojourn seeks to manage risk by moving to cash, Steve also uses trailing stop orders that close out trades should losses exceed a pre-determined percentage. In winning trades, these stop-loss orders ratchet up with gains, providing the potential to lock in a portion of any positive gains.

Steve does not employ any discretion in his program, so he will allow the system to stay in cash as long as necessary until the high-yield bond market environment improves. For example, the CHYB Program was in cash for much of 2008, which is why it ended the year with only a 2.9% loss rather than a drop of over 26% as was the case in the Barclays High-Yield Credit Bond Index.

Performance Evaluation

The consistency of CHYB’s returns continues to amaze me. While I know that past results can’t necessarily predict future returns, you have to be impressed with Sojourn’s returns since it began in 2002. And let’s not forget that there was a major bear market in this 10-year-plus actual track record. You can probably find an investment with higher returns or lower drawdowns, but I think you’d have to look long and hard for a program like CHYB with its combination of steady returns and low drawdowns.

Best of all, you can access this program for a minimum investment of only $25,000. Accounts are held in each client’s individual name at Trust Company of America. The account is completely transparent with 24/7 online access. The account may be closed at any time.

The Columbus High-Yield Bond Program celebrated its 10-year anniversary in September of last year. Here is the full story on Sojourn’s performance over that period of time:

Columbus High-Yield Bond Program

Columbus High-Yield Bond Program

Click here for a fact sheet with detailed performance information.

Conclusions – Time to Make a Decision

The best takeaway from Steve’s article above is his answer – “It doesn’t matter” when someone asks him about the direction of the high-yield bond market. When have you ever heard any market guru answer like that? Fortunately, Steve has the track record to back his claim that the direction of the market doesn’t matter as long as his tactical strategy can identify the trend and trade accordingly.

I am honestly at a loss as to why more of my clients and E-Letter subscribers haven’t invested in this program, especially with a minimum investment of only $25,000. I also know that some of my readers like to watch new programs that I introduce for a while before they invest. That’s not a bad idea, but CHYB isnot a new program. We have monitored its daily trading since we first introduced the program in June of 2006, hardly a new arrival. I have had my own money invested since that time as well.

If you’re looking for an investment that has stood the test of time and navigated multiple market cycles with both bull and bear markets, and unprecedented Fed monetary policy, Sojourn’s Columbus High-Yield Bond Program fits the bill. You can invest individually, through a trust or via your IRA.

Most importantly, if you are invested in long-only high-yield bond funds, you should definitely consider CHYB seriously before it’s too late. You need to know when it’s time to leave the party and move to the safety of cash (money market).

Wishing you steady profits,

Gary D. Halbert

IMPORTANT DISCLOSURES: Halbert Wealth Management, Inc. (HWM), Sojourn Financial Strategies, LLC (Sojourn), and Purcell Advisory Services, LLC (Purcell) are Investment Advisors registered with the SEC and/or their respective states. Information in this report is taken from sources believed reliable but its accuracy cannot be guaranteed. Any opinions stated are intended as general observations, not specific or personal investment advice. There is no foolproof way of selecting an Investment Advisor. Investments mentioned involve risk, and not all investments mentioned herein are appropriate for all investors. HWM receives compensation from the Advisors in exchange for introducing client accounts to the Advisors. For more information on HWM, Sojourn or Purcell, please consult their respective Form ADV Part 2, available at no charge upon request. Officers, employees, and affiliates of HWM may have investments managed by the Advisors discussed herein or others.

As benchmarks for comparison, the Standard & Poor's 500 Stock Index (which includes dividends) and the Barclays High Yield Credit Bond Index were used. Both represent unmanaged, passive buy-and-hold approaches, and are designed to represent their specific market. The volatility and investment characteristics of these indexes may differ materially (more or less) from that of the Columbus High Yield trading program since they are unmanaged Indexes which cannot be invested in directly. The performance of the S & P 500 Stock Index (with dividends reinvested) and the Barclays High-Yield Credit Bond Index is not meant to imply that investors should consider an investment in the Columbus High-Yield trading program, which is actively managed, as comparable to an investment in the “blue chip” stocks that comprise the S & P 500 Stock Index or the high yield investments that comprise the Barclays High-Yield Credit Index. Historical performance data from October 2002 through December 2005 represents a track record compiled by MoniResearch, an independent corporation, Steve Shellans, President. It is based on the signals provided by Steve Landis, is net of 2.5% annual fees, with no sales charges assessed. (The track record has been adjusted to show the deduction of fees quarterly rather than monthly.) Performance from January 2006 forward reflects the return of a representative account in Purcell Advisory Services Columbus High-Yield Bond Program. The representative account has the maximum fee (2.5%) withdrawn, has been in the strategy for no less than two consecutive months with no withdrawals, distributions or additions. Should the representative account fail to meet the criteria, another account that complies with the requirements will be substituted. Returns reflect the reinvestment of dividends and other earnings, and are net of all transaction fees and custodial fees. Neither set of these performance numbers have been verified by HWM, and therefore HWM is not responsible for their accuracy. Since all accounts in the program are managed similarly, the results shown are representative of the majority of participants in the Columbus High-Yield Bond Program.

Purcell utilizes research signals purchased from Sojourn, an unaffiliated investment advisor. The signals are generated by the use of a proprietary model developed by Sojourn. Assets in the program are allocated 100% to the appropriate mutual funds or 100% to the money market according to the purchased research signals. Statistics for "Worst Drawdown" are calculated as of month-end. Drawdowns within a month may have been greater. PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.

When reviewing past performance records, it is important to note that different accounts, even though they are traded pursuant to the same strategy, can have varying results. The reasons for this include: i) the period of time in which the accounts are active; ii) the timing of contributions and withdrawals; iii) the account size; iv) the minimum investment requirements and/or withdrawal restrictions; and v) the rate of brokerage commissions and transaction fees charged to an account. There can be no assurance that an account opened by any person will achieve performance returns similar to those provided herein for accounts traded pursuant to the Columbus High-Yield trading program.

In addition, you should be aware that (i) the Columbus High-Yield trading program is speculative and involves risk; (ii) the Columbus High-Yield trading program’s performance may be volatile; (iii) an investor could lose all or a substantial amount of his or her investment in the program; (iv) Purcell will have trading authority over an investor’s account and the use of a single advisor could mean lack of diversification and consequently higher risk; and (v) the Columbus High-Yield trading program’s fees and expenses (if any) will reduce an investor’s trading profits, or increase any trading losses.

Any investment in a mutual fund or money market fund carries the risk of loss. Mutual funds and money market funds have their own expenses which are outlined in the fund's prospectus. An account with any Advisor is not a bank account and is not guaranteed by FDIC or any other governmental agency. Management Fees are deducted quarterly, and are not accrued on a month-by-month basis. They do not include the effect of annual IRA fees or mutual fund sales charges, if applicable. Individual account results may vary based on each investor's unique situation. No adjustment has been made for income tax liability. Consult your tax advisor. “Annualized” returns take into account compounding of earnings over the course of an investment’s actual track record. The results shown are for a limited time period and may not be representative of the results that would be achieved over a full market cycle or in different economic and market environments.

© Halbert Wealth Management

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