This Junk Is Trash

Last week junk bond mutual funds saw net inflows of $534 million, the 11th week in a row that money came into junk. Since December the ML High-Yield Index has risen about 12%. In a world of low-single-digit interest rates on government bonds and certificates of deposit, investors find the 15% spread over comparable maturity treasuries too attractive to ignore.

This is plain old yield-reaching on the part of retail investors. I have seen other cycles in which this happened and it always has the same ending. Yield-reaching is somewhat akin to skydiving with no parachute: It initially may be exhilarating but the ending is brutal.

Junk bonds are one of my favorite playgrounds. In 2001 and 2002, I was buying junk with both hands, finding bonds trading at half my bankruptcy appraisal, which was still current on coupons. Everyone thought I was insane. No one wanted to touch junk, especially the tech dreck I was buying at the time.

Companies like Amazon (AMZN - commentary - Cramer's Take) and Adaptec (ADPT - commentary - Cramer's Take) with strong balance sheets had paper trading with returns in the upper teens despite piles of cash on the balance sheet. A few of them eventually failed, but the vast majority paid out with huge returns. I love that type of market and the current environment is nowhere close.

Most of the junk I see right now is junk. It is either automobile or finance paper from the General Motors (GM - commentary - Cramer's Take) and Countrywides of the world, or it is paper issued at the height of the bubble. A lot of that paper is so-called "covenant lite," with very relaxed covenants restricting the financial activity of the borrower.

It is junk with absolutely no margin of safety. A lot of these loans were made in conjunction with private equity buyouts that are now in very real danger of defaulting. Those high-yield spreads over Treasuries are a very real reflection that there is a good chance you will never see your principal repaid.

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At the time of publication, Melvin had no positions in the stocks mentioned, although positions may change at any time.

Tim Melvin is a writer from Stevensville, Maryland, who spent 20 years a stockbroker, the last 15 as a Vice President of Investments with a regional firm in the Mid Atlantic area. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Melvin appreciates your feedback; click here to send him an email.