Posted by: Aaron Pressman on April 17, 2007
Seems like everyone and their broker is calling for a decline in corporate bond credit quality, especially at the lower end of the ratings scale. The fund innovators over at Rydex Investments in Rockville, Maryland, are always eager to jump on a hot trend. This week they introduced two new mutual funds, the Rydex High Yield Strategy Fund (Symbol: RYHDX) and the Rydex Inverse High Yield Strategy Fund (RYILX). Both will be actively managed and carry management fees of 1.45%. But the idea isn’t to fill up the portfolios with long or short positions in actual junk bonds. Rather, following the trend of hedge funds and big institutions, the funds mainly will rely on credit default swaps.
These are privately negotiated contracts similar to insurance policies that pay off if a bond defaults or a company goes bankrupt. Neither Rydex fund is leveraged in the sense of providing double or triple upside and downside versus the general high yield market. Some of Rydex’s funds in other markets, like the Dynamic Dow Fund (RYLDX) which moves twice as much as the Dow does every day, do feature such leverage.
Unlike most mutual funds, Rydex allows almost unlimited trading amongst its funds, letting investors who so desire move in and out of positions in stocks, bonds, commodities and various sub-sectors. The firm has also turned many of its mutual funds into companion exchange-tgraded funds which certainly is a possibility for high yield. Current ETF offerings for high yield are rather sparse. Barclays just launched its iShares iBoxx High Yield Corporate Fund (HYG) last week.
A note of caution about investing along the lines that everyone says credit quality will crater — just because everyone says it doesn’t mean it’s true. Like small cap stocks continued domination of large caps, the steady performance of junk bonds has been attracting doubters for several years now. Moody’s the other day issued its first quarter credit survey and projections for the rest of the year. Junk bond default rates in the quarter declined to the lowest level in 25 years, with the trailing 12-month rate of defaults at 1.4%, down from 1.6% in the fourth quarter.
Sounds ripe for a turn but of course that’s what Moody’s was saying at the end of last year. The 2006 default rate on junk of 1.6%, also the lowest in 25 years, marked the fifth consecutive year that the rate dropped. Moody’s had been predicting the default rate would double to 3.1% in 2007 but in the first quarter release they’ve tempered the forecast to 2.7%. The long-run average is 5.1%.
Barring an economic calamity, those don’t sound like the makings of a junk bond apocalypse. Merrill Lynch’s high yield index has a total return of 3.2% so far this year, better than the returns of corporate or Treasury bond indexes hovering around 1% each, and even close to the S&P 500’s 4.1% total return year to date.