CB Richard Ellis, a highly indebted and thinly profitable commercial-realty brokerage, recently issued $350 million in ten-year bonds bearing an interest rate of 6.625%. They were rated double-B, putting them firmly in junk territory. Only 15 months earlier, Ellis had sold $450 million worth of bonds due in eight years with an interest rate of 11.625%. Same company, same ratings, roughly the same maturities and similar "covenants" (the conditions bond underwriters forced Ellis to accept).
Ellis, like the economy, is only marginally better off than it was during the recession. It has been paying down bank debt, and its stock (symbol CBG), after collapsing from $41 to $2, has recovered to $19. But commercial real estate remains weak -- and that's Ellis's only business. Yet not only will Ellis pay a lot less interest on its new bonds, it will pay a smaller "spread" relative to yields on Treasury bonds. The bonds it issued 15 months ago yielded eight percentage points more than the going rate on ten-year Treasury bonds. The bonds it issued recently yield just four points more than Treasuries.
Blowout Numbers
What's the explanation? Chalk it up to a rip-snorting bull market in junk bonds, which has allowed all sorts of marginal companies to lower their cost of borrowing. From March 9, 2009, when both stocks and junk bonds bottomed following a horrific bear market for both groups, through October 8, 2010, junk bonds have returned a cumulative 68%, on average. Much of that gain has come in the form of appreciation, and as prices have climbed, yields have fallen. Over the past year, a Merrill Lynch index of the 100 biggest high-yield bonds returned 19.4%. Junk bonds beat every other fixed-income category, including Treasuries and emerging-markets bonds.
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Investors, noticing the returns and desperate for yield, are pouring money into junk-bond mutual funds. That's worrisome, given the tendency of individuals to rush into an asset class after it has achieved the bulk of its gains.
But the junk-bond party may not be over yet. With high-yield bonds, identifying market tops and bottoms is fairly simple. When the gap between junk yields and Treasury-bond yields is four percentage points or less, that's usually an indication that junk bonds are expensive and that you should be trimming your positions. If the spread is greater than eight points, junk is a steal. Between four and eight points, hold your bonds and collect the fat interest payments. The typical junk bond currently yields more than five points more than Treasuries do, so the group is not in the danger zone yet.
To get more insights into junk's prospects, I consulted one of the fund industry's most experienced high-yield managers, Mark Hudoff, of Hotchkis and Wiley High Yield Fund. Hudoff, former head of global high-yield investments at Pimco, offers several convincing arguments why junk bonds aren't about to collapse. For starters, he says, managers of investment-grade bond funds are "reaching down" the quality ladder to buy sturdier junk bonds -- in particular issues, such as Ellis bonds, that could be in line for a ratings upgrade.
Second, says Hudoff, the timing is right for junk bonds. They usually perform well during the second half of a recession and in the early stages of subsequent expansion, before petering out as the economy starts to heat up and investors begin anticipating the next slowdown. Few would argue that the U.S. is anywhere near the late stages of a recovery.
Finally, Hudoff thinks that investors chasing high returns in emerging-markets bonds will get nervous, take their profits and repatriate their cash to America before any developing economies blow up. "I have a lot more confidence in Georgia-Pacific paying me back than I do in some of those countries," he says.
Jeff Kosnett is a senior editor at Kiplinger's Personal Finance.
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