In The Headlines
They’re Back – Junk Bonds Boom as Investors Seek Bigger Yields
After five and a half years of the Federal Reserve keeping short-term interest rates near zero, investors say they have no choice but to seek ever-riskier securities to generate any type of return. That means almost any borrower is able to sell bonds with few questions asked—whether it is a nation with a history of defaults or a corporation with an ultra-low credit rating. Even Japan’s risk-averse $1.25 trillion Government Pension Investment Fund said it is considering loosening its practice of only buying investment-grade debt and venturing into junk bonds. “You can stay in over exuberant conditions for a while,” says Fred Senft Jr., director of fixed income and equity research for Key Private Bank, “but when it turns, it will turn quickly and it will turn very ugly.”
The value of bonds tracked by the Bank of America Merrill Lynch Global High Yield Index has soared to more than $2 trillion. It took 12 years for the index, started at the end of 1997, to reach $1 trillion, and only four years to add another trillion. More than $350 billion of high-yield debt has been sold this year, putting 2014 on track to top last year’s record $477 billion.
So far, investors appear to have been rewarded. Junk-bond investors have enjoyed a total return of 157% since the depths of the 2008 financial crisis as measured by Bank of America Merrill Lynch indexes. That is better than the 122% for the MSCI All Country World Index of stocks.
So eager are investors for high-yield debt that borrowers increasingly are dictating their own terms. Moody’s Covenant Quality Index for junk bonds, which tracks the strength of investor protections in high-yield bond contracts, is at almost its weakest level since it was created in 2011. For the first time, more than half of the junk-rated loans made in the U.S. are “covenant-light,” meaning they lack typical lender safeguards such as limits on the amount of debt a borrower can amass relative to its earnings.
Investors are relaxed because central banks are doing so much to support the market. The Fed has injected more than $3 trillion into the global economy through its bond purchase programs. The European Central Bank has provided about $1 trillion of emergency loans to banks. Japan’s central bank has been buying $69 billion of bonds per month through its own quantitative easing measures. Central banks’ largesse means that borrowers who otherwise would have defaulted have been able to refinance and extend maturities, giving lenders few reasons to worry. The global junk-rated corporate default rate fell to 2.2% in June, according to Moody’s. The company sees the rate finishing the year at 2%, well below the historical average of 4.7%.
While keeping rates low, central bankers have started to say they are worried that investors are too complacent, thus increasing chances for future market instability. Fed Chair Janet Yellen said in June that she was concerned about “reach-for-yield behavior.” Bank of England Deputy Governor Charlie Bean said in May conditions were “eerily reminiscent” of the pre-crisis era (he left office last month). Bundesbank board member Andreas Dombret said in June that “we do see risks, despite the fact that the markets are calm.” The day of reckoning may be within view. Junk-rated borrowers have $737 billion of debt due in the next five years, peaking in 2018, according to a Moody’s report in February.
That prospect has not deterred investors, who keep paying higher prices for risky debt, driving yields down (yields fall as prices rise). Since peaking at 23.2% at the end of 2008 during the financial crisis, average junk-bond yields tumbled to a record-low 5.6% last month, according to Bank of America Merrill Lynch index data. Martin Fridson of Lehmann, Livian, Fridson Advisors, who started his career as a debt trader in 1976, has rarely seen a market so unworried about defaults. “It’s about as extreme as it gets,” he says.
Mattel Looks to Create the Next Big “Toy Platform”
Mattel believes that the key to selling more toys is a strong level of personal interest in the brand among children and their parents. The toy company is establishing a direct-to-consumer program to sell a premium line for its Thomas & Friends Wooden Railway tracks and engines brand. Part of Mattel’s Fisher-Price unit, the wooden-toy line will be sold via catalog, an e-commerce website, and through a partnership with 20 specialty stores nationwide.
Mattel plans to publish the catalog three times a year. The first one will be mailed next week to 1.3 million homes. Inside, the glossy pages will feature some exclusive sets and characters, including one that will be offered in limited release every year. For Fisher-Price, the direct-to-consumer model is a natural fit for the Thomas & Friends brand. “Kids that collect Thomas are more passionate about the story line and the characters,” said Geoff Walker, executive vice president for global brands at Fisher-Price.
Mr. Walker said the company’s inspiration came from the success of a similar program for American Girl, a popular line of dolls and accessories. Mattel reported an 11% rise in gross sales worldwide for American Girl in 2013, the company’s only core brand to show an increase last year. Building on that model, Mattel is trying to leverage an existing infrastructure that could, in turn, be applied to other toy lines.
A catalog helps build brand awareness, said Jaime M. Katz, an analyst at Morningstar, because it puts a universe of products in the hands of the child. “Kids see it, and they want it,” she said. “You have the train; don’t you want the track? It’s a complementary business.” But more important, it also appeals to parents, she said. “It’s really the parents who are driving those sales home.”
Other companies have direct-to-consumer programs, but they are primarily intended to promote a particular brand and encourage fans to participate. Their e-commerce websites offer toys that can typically be found at most stores. One exception is the Danish toy company Lego. It has an e-commerce website that features exclusive sets not found in stores. It also sends a magazine to members of its Collectors Club, an online community that encourages fans to share photos and videos. Lego officials declined to comment on its direct-to-consumer strategy.
Although the Thomas & Friends Wooden Railway toys have been around for years, Mattel only recently acquired the rights to make them. Mattel bought HIT Entertainment, the home of Thomas and other preschool brands, from the private equity firm of Apax Partners in 2011. At the time, Mattel was already making toys for HIT, selling $150 million worth of Thomas the Tank Engine plastic and die-cast toys in 2010, so the acquisition made sense. But it was not until 2013 that Mattel acquired the rights to Wooden Railway, one of the longest-running Thomas merchandise lines.
Because the toys are made of wood, they cost a little more than their plastic counterparts. “This is a premium segment of the brand; the consumer expects to pay a little more for the product they get,” Mr. Walker said. The higher price does not faze some parents. As children grow out of Thomas, the wooden trains are often handed down to younger siblings and cousins. Mattel is hoping this new model for selling toys will revive its lackluster toy sales.
Sources:
1. http://buswk.co/1nJsQg6 – BusinessWeek
2. http://bit.ly/1yIRJAV – US News & World Report
The Good News Is . . .
• A gauge of future U.S. economic activity rose in June, supporting views of a stronger growth performance in the second half of the year. The Conference Board reported that its Leading Economic Index increased 0.3% last month after an upwardly revised 0.7% rise in May. Broad-based increases in the leading economic indicators over the last six months provide evidence of an economy that is expanding.
• Johnson & Johnson, Inc., a global consumer healthcare company providing pharmaceuticals, medical equipment, diagnostics, and biologics reported earnings of $1.66 per share, an increase of 12.2% over year-ago earnings of $1.48. The firm’s earnings topped the consensus estimate of analysts by $0.11. The company reported revenues of $19.5 billion, an increase of 9.1%. Management attributed the company’s performance to the success of its new products designed to treat chronic diseases such as hepatitis C and diabetes.
• Gtech, the operator of the Italian lottery, agreed to acquire the slot machine maker International Game Technology of Las Vegas for $4.7 billion in cash and stock. The companies will form a new holding company in Britain. Shareholders of I.G.T. will receive $13.69 in cash and 0.1819 of a share of the new company for each I.G.T. share. The new entity will have over $6 billion in revenue and estimated pre-tax earnings of more than $2 billion. The company will become the dominant player in an industry facing sluggish growth and increased competition.
Sources:
1. http://bit.ly/1eqT6Of – The Conference Board
2. http://www.cnbc.com/id/18080780/ – CNBC
3. http://bit.ly/1qRMbj9 – Johnson & Johnson, Inc.
4. http://nyti.ms/1np8OgH – NY Times Dealbook
Planning Tips
Tips for Understanding Bond Ladders
A bond ladder is an investment management strategy for the fixed-income part of a retiree’s portfolio that can provide the ability to more precisely match income with future cash flow needs. As with all investments, however, there are potential risks and downsides, and the use of bond ladder strategy should only be undertaken with the help of an experienced financial advisor. Below are some tips to help you better understand how bond ladders work.
Learn what bond ladders are – A bond ladder is a portfolio of fixed-income securities in which each security has a significantly different maturity date. The purpose of purchasing several smaller bonds with different maturity dates rather than one large bond with a single maturity date is to minimize interest-rate risk and to increase liquidity. In a bond ladder, the maturity dates of the bonds are evenly spaced across several months or several years so that the bonds are maturing and the proceeds are being reinvested at regular intervals. The more liquidity an investor needs, the closer together his or her bond maturities should be.
Work with your financial advisor – Bond ladders can be complex and you should work with your financial advisor to determine whether they are appropriate for you and, if so, help you evaluate such things as:
• Credit quality of the bonds you buy
• Tax characteristics of the interest income
• What account to buy the bonds in (IRA, or non-IRA, for example)
• How to account for and use the interest the bonds produce before their maturity year
• The brokerage service or account that can facilitate the purchase of the bonds
Understand how bond ladders are structured – To build a bond ladder, you purchase bonds in your account so that the maturity dates of the bonds are staggered, or laddered, across a specified period of time. Sometimes this is called asset-liability matching, meaning you have an expense coming up (such as a year’s worth of retirement spending) so you buy an asset (a bond) that will be available to meet that expense when it occurs. Ladders can include Treasury notes and bonds, but also higher-quality corporate and municipal bonds when appropriate. Plentiful, actively traded issues are the best fit for bond ladders. Investors ideally hold each issue to maturity, collecting interest payments, and then often reinvest the principal to extend the ladder.
Compare the inflation risk for bond ladders vs. individual bonds – Bond ladders offer some inflation protection over individual bond ownership. Investors are insulated from a spike in inflation and rising interest rates because they will have regular cash to roll over into new bonds at higher rates. Inflation is among the biggest risks facing bond investors overall. It erodes the value of the fixed payments collected on bonds.
Evaluate your ability to buy and hold – The effectiveness of bond ladders hinges primarily on whether an investor truly follows a buy-and-hold philosophy. Predictable income and the ability to manage interest-rate and credit risk are tied to holding bonds until maturity. If you have to sell early, maybe for an unexpected expense or because you want to invest elsewhere, you will be exposed to additional risks.
Sources:
1. http://bit.ly/1rzVzsY – TheMotleyFool.com
2. http://bit.ly/1oWcPER – US News & World Report
3. http://bit.ly/1mrMVHE – Investopedia
4. http://abt.cm/1sAS6wN – About.com
5. http://bit.ly/1n4jtvB – Kiplinger
6. http://bit.ly/1k38zaS – Zacks.com
