Playing the Increase In Junk Bond Yields Written By: David Neubert 2007-10-08 13:10:11 I started a small position in the Morgan Stanley High Yield Fund (MSY - $5.76) today. According to the Closed-End Fund Association website, the Morgan Stanley closed-end fund is trading at at 14% discount to Net Asset Value of $6.72. The recent increase in junk bond yields (drop in prices) has made me neutral on the sector (from negative).
MSY analysis:
Positives:
1. Junk bond (non-investment grade) yield spread have increased lately, meaning investors get paid more for taking additional risk.
2. MS High Yield fund is at a big discount. I'm buying the underlying bonds at a 14% off to what it would cost to buy them directly. Now there is no guarantee this discount will close, but a 15% discount does tend to set a floor for this fund.
3. Yield of 7.5%
Negatives:
1. Rising defaults on junk bonds could hurt this fund.
2. Potential for rising interest rates.
3. The huge expense ratio 2.00% charged by Morgan Stanley Asset Management for managing this fund should keep the discount to NAV from improving all the way to zero.
Disclosure: I own MSY as described above. I may buy more in the near future, depending on prices and market conditions. I may also sell this fund and switch to Indexed Exchange Traded Fund that specializes in junk bonds like (HYG - $104.39) if the discount to NAV closes significantly.
I have been previously employed as a Managing Director at Morgan Stanley. I worked in the equity trading division and did not deal with Morgan Stanley Asset Management. I am still vested in their pension and executive compensation plans. I own Morgan Stanley (MS) stock.
I still think the fact that John Thain got to look at the firm's books and still wanted the job means that there is probably no huge surprise write down coming. Remember, this guy grew up at Goldman as a mortgage trader and knows all the trader tricks for hiding losses in a mortgage/CDO trading book.
However the market is still pricing in more negative surprises, so that means MER cheap here. I've decided it will likely get cheaper so I'll be greedy. After putting my toe in the water and buying the first part of building a position on his announcement I've decided to hold off on adding more.
I continue to buy overweight financials, especially the big ones like Citigroup (C), Bank of America (BAC), JP Morgan Chase (JPM), Morgan Stanley, Goldman Sachs (GS) and Lehman Brothers (LEH). I'm even short some puts on the Financials ETF (XLF). In the short term, financials have to go higher as hedge funds cover shorts and, more importantly, mutual fund managers buy to correct the underexposure to the financial sector. Most Fed easing cycles imply very good returns if you buy just as they begin. The exceptions? The last one. I'm hold financials for the short run but I'm going to lighten up on these as this rally progresses. Why? The recipe is in place for some stagflation.
Stagflation is a period of inflation and low or no growth in the economy. The last time this existed was back in the 1970's in Britain and the US.
