Wednesday, June 13, 2012

Levine, How to Make Money with Junk Bonds

Robert Levine’s How to Make Money with Junk Bonds (McGraw-Hill, 2012) is a first-rate introduction and navigation guide to the high-yield world. Starting with an analysis of the fictional Millie’s messenger company and her eventual leveraged buy-out of the competition, Billy’s Messengering, Levine explains how to find good investment candidates. (Poor Millie’s doesn’t cut the mustard.)

At the core of successful junk bond investing is credit analysis. The investor has to assess a company’s business risk, financial risk, and covenant risk before he can decide how much risk he himself is willing to assume in buying the company’s bonds and how much he wants to be paid to assume this risk.

Levine advocates a two-step approach to investing in junk bonds, what he calls the Strong-Horse Method, an image that evokes power and speed. The first step is credit analysis: “A Strong-Horse company is one that can improve in creditworthiness and generate excess cash flow to pay down debt over time.” (p. 43) The second step is to “relate the results of the Strong-Horse credit analysis to the yield of the bond. … [S]potting an underrated credit can yield additional coupon while the price simultaneously increases.” (pp. 47-48)

In keeping with the classic value investing mantra—buy low, sell high—Levine explains that “You should buy or own Strong-Horse companies when spreads are at the widest level (lowest prices), and you should not own the bonds when the spreads are tight, that is, when the yields are low and the prices high.” (p. 56)

Levine fleshes out his method, which has outperformed both the S&P 500 Index and the BoA Merrill Lynch High Yield Index for the 1-, 5-, 10-, 15-, and 18 ½-year periods, with multiple examples. He offers caveats. And he explains the logistics of investing directly in junk bonds as well as investing in junk bond mutual bonds. All this in clear prose that even someone with no experience in junk bonds can understand.

The underlying message of this book is that high-yield bonds are not intrinsically high risk; in fact, they “fit between stocks and bonds along the risk spectrum.” (p. xvii) As such, they can be a value-enhancing addition to an investment portfolio. How to Make Money with Junk Bonds points the way.

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