IN THIS ISSUE:

1.  CDs & Money Markets Return Almost Nothing.

2.  High-Yield Bonds – Are They Just Too Risky?

3.  Maybe, But Not If You Use This Timing Strategy.

The Yearn For Return

With CD and money market rates so low, and with stocks in the doldrums, many investors are asking where they can invest their money to obtain a meaningful return without undue risk.  Because interest rates are so low, telemarketers and direct-mail houses are touting “sure bet” investments they claim will do extremely well in this time of uncertainty.  I’m sure our readers are smart enough to “just say no” on these schemes, but the question still lingers: Where can I invest my money today?

One bright spot on the investment horizon has been High-Yield Bonds (“HYBs”), also known as “junk bonds.”  Many HYBs offer yields that are 10 percentage points higher than Treasury bonds.  So far this year, the average HYB mutual fund is up 7.9% according to Morningstar, with several well-known funds up double digits.

Still, are junk bonds a good place to put some of your money?  This week, I’ll discuss the pros and cons of HYBs and how they can fit into a diversified portfolio.  As with most other investments, there is a good way to invest in HYBs, and there are several very bad ways.

The Basics

HYBs are issued by organizations that do not qualify for “investment grade” (BBB- or better) ratings by one of the leading credit rating agencies.  True to their name, HYBs generally offer greater yields to compensate for a significant increase in credit risk.   Clearly, companies that can’t qualify to issue investment grade bonds have a higher risk of default than those that can sell higher grade bonds.  Here are some recent average yield quotes on various classes of bonds.

The yield spreads among the various grades of bonds are significant.  The higher the perceived risk of holding the bonds, the higher the yield.  The spreads between HYBs and Treasuries recently hit a historically high level. 

Special Risks With HYBs

HYBs have the same risks as any other bonds - interest rate risk, economic risk, credit risk - plus others.   When you buy investment grade corporate bonds, you generally don't worry about the company defaulting or going bankrupt, although it can happen.   But with HYBs, there is not only the higher risk of default, but there is also a higher incidence of “downgrading.”  The company’s credit rating may be downgraded while you own its bonds, and this almost always leads to a decline in the value of those bonds.

Another risk that is typically not an issue with investment grade bonds is liquidity risk.  Liquidity risk refers to the investor’s ability to sell a bond quickly and at an efficient price, as reflected in the bid-ask spread. High-yield bonds can often be less liquid than investment-grade bonds, depending on the issuer and the market conditions at any given time.

The return spread between HYBs and Treasuries takes into consideration these different kinds of risk.  According to a recent analysis from T.D. Waterhouse, the historical total spread between Treasuries and HYBs is 4.5% to 5.5%.  Default risk makes up about 45% of this differential, and liquidity risk makes up the remaining 55% of the spread.

A “Hybrid” Investment?

We are now in the third year of a bear market and coming out of a recession.  Most economists are predicting that the economy will continue to get better.  As the economy recovers, there is an increased likelihood that interest rates will also rise.

The conventional wisdom surrounding bonds is that you do not invest in bonds during periods of time when interest rates will rise.  This is based on the sound principle that the prices of most bonds decrease if prevailing interest rates increase.   This inverse relationship between bond prices and yields is what drives most of the trading in the bond markets today.

HYBs, however, do not always conform to the conventional wisdom in an economy on the rebound.  Historically, HYBs have led the way out of recessions.  For example, HYBs posted a gain of over 70% in the three years following the 1990/91 recession. 

One reason is that HYBs are correlated to stocks as much as they are to bonds.  A recent study by Ibbotson Associates shows that the correlation between HYBs and the S&P 500 was 0.5 over a period of 22 years.  This means that HYBs tend to track the performance of stocks about half of the time.  The same Ibbotson study shows that HYBs also have a 0.5 correlation to the Lehman Aggregate Bond Index.  Even though HYBs produce stock-like returns in periods of recovery, historical volatility is less than stocks.

Thus, as the economy begins to expand again, generally speaking, many companies that issue HYBs are better able to service their debt from cash flow and the prices of these bonds rise accordingly.  Oftentimes, the credit rating of these companies goes up as well, and this can lead to even more appreciation in their bonds.

At this point you may ask what happens if the economy doesn’t continue to improve.  The outlook for HYBs continues to be good.  With the historically high spread between HYBs and Treasuries, yield-hungry investors are searching for assets with a higher return.  This bodes well for the price of HYBs as compared to lower-yield corporate issues.

How To Invest In HYBs

HYBs are risky and NOT suitable for all investors.  But for sophisticated investors, I think HYBs deserve a place in a diversified portfolio.  The key is how you invest in this market.  Let’s discuss that. 

First, given the special risks noted above, most people should not invest in individual issues of HYBs on their own.  Very few of us are credit experts.  There are bond dealers and brokers who specialize in HYBs, and they may be able to steer you in the right direction.  However, I would not recommend going this direction as it is difficult to find a dealer or a broker that is really an expert in this complicated market.

Second, even if you do find a broker who is experienced in this market, the most critical part of investing in HYBs is diversification.  With the higher risk of default and the other risks noted above, investors need to be able to purchase numerous different issues of HYBs.  The best way to do that is to invest in a high yield bond mutual fund(s).  Most HYB funds invest in dozens, or even hundreds, of HYB issues.  Different companies, different credit ratings, different maturities, etc.  HYB funds have a professional manager, usually with a team of analysts, that research the various companies with whom the fund invests.

As noted above, most investors are not skilled in analyzing corporate financial statements, even those from large Fortune 500 firms, much less those who issue HYBs and may be having financial problems.  Therefore, I would only recommend investing in HYBs through a mutual fund that specializes in them.  And you should be very selective in the fund(s) you choose (more on this below).

The combination of wide diversification and thorough due diligence helps to reduce the default rate and the other risk factors noted above.  This is why I would only invest in HYBs through a mutual fund that has a diversified portfolio AND a professional management team that specializes only in this area.

Selecting The Right Fund

According to our Morningstar database, there are over 130 mutual funds that are distinctly classified as specializing in high-yield bonds.  If you look into all of the various classes of shares in these funds, the number swells to almost 400 funds.  Selecting one fund from among this large number of contenders is a difficult task for most individual investors.

If you have access to Morningstar or one of the other fund rating services, you can “slice and dice” among all the funds to find those that meet your particular performance preferences.  Note that this can be deceiving because the latest hot performing funds may NOT be the best performers over a longer period of time.  You also have to pay particular attention to the funds’ losing periods to see if they would have been too great for your stomach to handle.

Even the best mutual funds encounter periods of time when their strategy does not pay off.  That’s why it is important to have diversification among many different asset classes.  As of the end of February 2003, the top ranked high-yield bond mutual fund based on its 10-year average total return was the PIMCO High-Yield Fund , with an average total return of 7.7%.  This compares favorably to the Morningstar average for all HYB funds of only 5.2%, but the road to this return was somewhat rocky.  The PIMCO fund suffered a worst-ever drawdown (losing period) of over 11% during this 10-year period of time.

Enhanced Returns Through Market Timing

To soften the ups and downs of the HYB market, another way to invest in high-yield bonds is through Capital Management Group (CMG).  CMG is a Registered Investment Advisor that specializes in high yield bond funds.  They manage accounts for individual investors and institutions.

Since the inception of its bond programs in January of 1992, CMG has produced average annualized returns of over 11% in its non-leveraged program, and almost 17% in its more aggressive leveraged program (net of all management fees and expenses).  That’s 10 years of outstanding performance!

CMG’s high-yield bond fund strategy is to be in the market when conditions are favorable, and out of the market when risks increase.  If CMG’s system indicates that risks are too high, they simply switch (partially or fully) to a money market fund.  This ability to jump out of the market when risks are high is a key to successful market timing, and CMG has proved to be very adept at it.

One of the most impressive parts of CMG's program is its ability to control risk.  The non-leveraged program has a worst-ever drawdown (losing period) of only -3.28%, while the leveraged program drawdown is slightly higher at -7.34%.  Still, it is extremely rare to find a manager who can provide both superior performance and limited risk over a period of 10 years. (Past performance is not necessarily indicative of future results.)

Since the beginning of the bear market in 2000, many investors have stopped looking at long-term track records in favor of scrutinizing what has happened over the last three years.  CMG invites this scrutiny.  Here are their results during the bear market:

I know that many of you are afraid to commit money to any investment during this time of uncertainty in the world.   However, CMG has shown the ability to manage high-yield bond funds effectively, not only during the go-go days of the 90’s, but also during the bear market in stocks over the last three years. 

How To Get Started With CMG

My company, ProFutures Investments, refers clients to CMG.  We introduce clients to them.  To obtain more detailed information about CMG and its programs, you can call us at 800-348-3601 or you can go to our website at www.profutures.com.  You can also read my Special Report, “How To Own Bonds Now” by clicking on the link below.

We will send you the necessary account papers to open an account.  Accounts are held at Trust Company of America (TCA) in each client’s individual name.  CMG is given a limited Power of Attorney to direct trading in the account.  They invest in several different high yield bond mutual funds.  Investors receive a monthly account statement showing all activity and month-end balance.  You can also access your account online. 

CMG charges an annual management fee of 2¼% of assets.  Fees are deducted from the account on a quarterly basis.   You should also know that CMG shares a portion of its management fee with my company.  That is how we are compensated for finding and evaluating top-rated professional money managers.

CMG accepts accounts as small as $25,000.  Steve Blumenthal, CMG’s founder and president has remained committed to smaller investors, even though they manage accounts over $1,000,000 in size.    

Conclusions

Most investors should not invest in high yield bonds on their own.  The risks in buying individual HYBs are just too great.  Buying high yield bond mutual funds is usually a much better way to go since it gives both the diversification needed and professional management.  Obviously, I believe that Capital Management Group is the best way to invest in HYBs for those investors who are suitable.

CMG has averaged 11% returns over the last 10 years with a worst drawdown of only 3.3% (non-leveraged).  This beat the returns of high yield mutual funds, and with less volatility.  I encourage you to check out this very impressive program.  

May Newsletter Now Online

The May issue of my monthly Forecast & Trends newsletter is now available online at
http://www.profutures.com/article.php/161/

Best Wishes,

Gary D. Halbert

SPECIAL ARTICLES

“How To Own Bonds Today”

http://www.profutures.com/article.php/79

IMPORTANT NOTES:  ProFutures Capital Management, Inc. (PCM) and Capital Growth Management (CGM) are Investment Advisors registered with the SEC and/or their respective states.  This report does not constitute a solicitation to residents of any jurisdiction where the program mentioned may not be available.  Information in this report is taken from sources believed to be reliable but its accuracy cannot be guaranteed.  Any opinions stated are intended as general observations, not specific or personal advice.   This publication is not intended as personal investment advice.  Please consult a competent professional and the appropriate disclosure documents before making any investment decisions.  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.  PCM receives compensation from CGM in exchange for introducing client accounts.  For more information on PCM or CGM, please consult Form ADV II, available at no charge upon request.  Officers, employees and affiliates of PCM may have investments managed by Advisors discussed herein and others. As benchmarks for comparison, the indexes used represent an unmanaged, passive buy-and-hold approach.  The volatility and investment characteristics of the benchmarks cited may differ materially (more or less) from that of the Advisor.

The individual account performance figures reflect the reinvestment of dividends, and are net of applicable commissions and/or transaction fees, CGM investment management fee, and any other account related expenses.  Past performance may not be indicative of future results and does not guarantee positive returns.  The performance results have been compiled solely by CGM and have not been independently verified.  In calculating account performance, CGM has relied on information provided by the account custodian. The CGM Risk Management Plan is a technically based strategy offered by Capital Growth Management, Inc.  These illustrations are based on actual account performance from 2000 to present (Trust Company of America client accounts).   The results from November 1992 to 2000 are based on our actual trade signals applied to the Funds. Since these results do not represent actual trading, and they do not reflect the impact that material market and economic factors might have had on the Advisor’s decision-making if the Advisor were actually trading client money during this period.

CGM trades various high yield bond funds.  CGM traded most of the stated funds but not all funds for the period reflected. The above accurately reflects the blended results of an assumed investment in the Funds when applying our actual trade dates for the period indicated and under the conditions stipulated when applying the risk management techniques to the actual price movements of the Funds. CGM trades various High Yield Bond Funds.  CGM traded most of the stated funds but not all the funds for the period reflected. This illustration should not be construed as an indication of future performance which could be better or worse than the period illustrated.  The period (1992-1997) was a period of generally rising fund prices. The period 1997-2001 was a period of generally declining prices.  A money market rate of 5% was assumed from 1992-1999.  All dividends and capital gains have been reinvested.  Investments in mutual funds are not FDIC insured.  Statistics for “Worst Drawdown” are calculated as of month-end.  Drawdowns within a month may have been greater. Investment returns and principal are not guaranteed.

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