Sunday, March 29, 2009

The J-Word

(ED: A few days ago, I wrote about bonds, in general. Follow this link. It’s an easy read).

JUNK. JUNK. There…I wrote it. A financial slur. This one regularly tossed at “high-yield” bonds…those “outcasts” of the investment world.

And “high-yield” isn’t necessarily right, either, because the yield may not be THAT high.
The right term would be “low-rated”, because junk bonds are only “JUNK” because someone has deemed them to be such. That “someone” is none other than the rating agencies (i.e. masters of the universe – holders of the absolute truth), S&P, Moody’s and Fitch. Yes, these are the same people who told us that MBS (mortgage backed securities) were AAA and Lehman Bros was “investment grade” (until it wasn’t).

S&P Ratings Explained

The S&P rating system is simpler than it looks, think grade school: letters and pluses or minuses. A twist is that you can have more than one letter. Rules of thumb: Higher letter, better, more letters better; a plus sign beats no sign and minus is worse than no sign.
So A beats B; BB- beats B+; and B- beats CCC+. Get it? If not wikipedia will answer.
BBB- is the limit of respectability…everything below that is labeled with the J-Word.
D is for default and not death, because there IS life after default.

Why do they rate bonds as “junk?”

Usually, these issuers or bonds have some imperfection or flaw. Either the company is small or its in a tough industry, it might have a significant amount of debt or maybe it isn’t familiar or “American” enough. In other words, there is more risk that it may default (in the opinion of the credit agencies).

So what?

It’s just someone’s opinion, right? The same as if an analyst said BUY, HOLD or SELL on a stock, right? Unfortunately, NO.

The problem is t that the “junk” label is almost a curse. There are serious consequences to carrying it.

The media calls these bonds “too risky” and “only for pros”. Regulators tend to concur and it can be considered an “inadequate” investment for a conservative investor (advisors can be sued for recommending them). There are a considerable number of brokers/banks who REFUSE to offer “high-yield” bond recommendations. Additionally, junk bonds cannot normally be used as collateral for a margin loan, while any old stock over $5 will usually do. Only a handful of online brokers will offer them as an alternative to clients. Furthermore, a number of pension or retirement funds have statutory prohibitions concerning investing in “junk” while they can buy all the equities or leveraged hedge funds they like. More than a label, it’s a stigma.

This is incredibly unfair. Let’s not forget that bonds AS A CLASS are less risky than stocks. But the stock of the SAME issuer can be considered an “adequate” or even “conservative” investment suitable for everyone, while its corporate debt (bond) is deemed to be “junk” and only the “pros” are allowed to go near them.

Here’s a practical example, straight from my wife’s (junk) bond portfolio:

She holds Davita bonds carrying a 6.625% coupon, maturing March 15, 2013 (about 4 years), currently trading at about 97% to yield 7.3%. (high yield? hardly) These bonds are rated B+ by S&P, so they are not “borderline”, they are solidly in “junk” territory.

FYI, DAVITA is a company that operates kidney dialysis centers. It’s a stable business (if you need it, you need it) and sadly also a growing business. Recession-resistant? Probably. Doesn’t seem like a discretionary expense.
Notwithstanding, the company has a significant amount of debt (not unlike a utility) and default is always a possibility.

Oh...and Davita’s stock is also publicly traded (DVA). Currently at $43, it has weathered the crisis relatively well and is considered to be “defensive” for obvious reasons.
No broker or advisor would be open themselves up to liability if they recommended this stock to a conservative investor. But if they recommend (or buy) the bond…it’s junk and they open up a fiduciary can of worms (if it goes bad, of course).

For those who don’t get just HOW unfair this is; Davita STOCK would have to go practically to ZERO before default is a factor for the bonds. And EVEN in the event of default, bondholders can expect to come away with something. But Davita stock is “defensive” and you can use it for margin while its bonds are “junk” and worthless as collateral.

This is exactly what happens when regulators use a third party opinion (the credit agency) as the basis for policy. And investor “protection” takes on a whole new meaning when those investors willing or needing to take a little more risk for a higher return, end up invested in offshore CDs, hedge funds, REITS or high-risk equities…instead of some good old boring bond, which could have served them well. Just because somebody called it “junk”.
It’s financial bigotry at its worst.

So, as an equal opportunity investor…I like junk, I wish it were more available, had better markets and were easier to acquire and trade. It deserves a place on the menu and certainly a better rap.

And as a believer in free markets, I wish that some day, stocks and bonds -investment grade and junk (and even distressed)- along with derivatives of all kinds could join together and trade freely in more efficient and transparent markets, for the benefit of all.
Without the J-word.


  1. You raise some interesting points in your post, but I'm not sure that I agree that high yield bonds should be allowed to use for margin. It does seem funny that the underlying stock can be used, but there is more liquidity in stocks and just because a stock probably shouldn't be used for margin, doesn't necessarily mean that their bonds should be. Seems like the better solution would be to only allow margin on stocks that have better than a BBB+ rating on their debt, but that wouldn't necessarily protect the banks or client from declines. Even good strong companies can go down in value. It'd probably be an even better idea to have a system not tied to the almighty rating agencies, but I won't hold my breath waiting for that to happen.

  2. If liquidity is the issue, then let that be the criterion (for allowing a security to be marginable). But if "riskiness" is going to be the criterion, let's at least try to use is half-consistently.

    I was just using margin as an example of irrational bias towards junk. The leverage of bonds in general varies. You can get up to 85%-90% lending value on a quality bond and maybe 50% on a BBB. Junk usually nada.

    I don't think the idea is to protect the bank or client from risk, but that risk is assessed in a much more equitable and rational way. I think we can all agree that the markets need better risk-management and distribution, but not necessarilly less risk (at least IMO).

    Nice to see you didn't use the J-word. LOL.