The Tycoon Report

Why the Junk Bond Market is More Overvalued than the NASDAQ was at 5,000.

The high-yield bond market is arguably more overvalued than the NASDAQ was at 5,000.Why you should be selling your junk bonds right now.

 THE END OF THE BULL MARKET IN BONDS MEANS DANGER AHEAD Warning, warning... At the end of a bull market, optimism is at its peak. And when optimism is at its peak, reason is at the trough. It’s at this point that every person you know wants to get a piece of the next hot IPO. Anybody who remembers the roaring 90’s knows what I’m talking about.

In 1997 it was strong, truly innovative companies like Yahoo and Ebay that went public. By 2000 it was the copycats - guys trying to get paid IMITATING market leaders like Yahoo and Ebay that were going public. And investors wanted all they could get. Why?

Because your next-door neighbor got 3,000 shares of EBAY at the IPO price. And having watched them make a quick $400,000, add a wing to the house and a cocky stride could be difficult even for the most Bohemian of people.

Hence the point that you could tell when a bull market is coming to an end by the “quality” of companies going public. The worse the quality, the closer you are to a bear market. And right now that’s what’s happening in the junk bond market.

Let me explain. In 2002 newly issued junk bonds made up roughly 2 percent of all corporate debt issued. This year it’s expected to jump to roughly 16 percent – almost an all-time high. That tells me that companies with shaky balance sheets – the equivalent of weak dot-com companies - are rushing to borrow as much money as they can while the getting is still good. But that’s about to end. And end in a big way.

Why?

For a couple of reasons. For starters it simply doesn’t PAY to be invest in junk bonds right now. That’s due to the fact that the spread between risky junk bonds and safe US Treasuries is at a measly 3.6 percentage points. Why is the spread so important? Because it shows the risk premium investors are getting for investing in junk bonds.

And if you’re taking on too much risk and not getting paid enough to do it, something’s gotta give.

Here’s an example:

Let’s say you could buy a risk-free, tax-free US Treasury bond with a yield of 4 percent. Compare that with the risky, TAXABLE yield of 7.6 percent you get for junk bonds and there is a problem. Why? Because junk bonds rated below BBB default 29 percent of the time within the first year of issuance. What’s even worse is that they default an astounding 48 percent of the time within five years. And assuming you hold your bonds for at least five years you have to ask yourself the following question:

Is 3.6 percent ABOVE Treasuries enough for a risk of almost 50 percent default rate? Not on your life. But that’s only part of the problem. The other part is that the FED is raising interest rates. That means the price of money is becoming more expensive. And when the price of money goes up, the price of bonds go down. So do the price of stocks.

What does this mean to us as investors? Here’s the advice I'm giving my Mom:

1. On the debt side, I’d be selling all my junk bonds in a hurry.

2. On the equity side, I’d be taking profits in any small-cap stock that has had a good run.

3. I’d also be combing my portfolio to make sure I didn’t own any ompanies that have a debt-to-equity ration higher than 30 percent.

Personally I don’t mind taking calculated risk. But history suggests that owning any of the above would be more than a calculated risk – it would be more like shooting craps w here the odds on favorite is a house win.