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Getting a craving for some "junk" bonds

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Every so often, a 401-k or even a retirement account needs a little "junk" food. As it pertains to the fixed income portion of your portfolio, that might mean some exposure to the higher risk/higher potential return and YIELD of the junk bond market.

Junk bonds got their name partially due to their higher risk as the underlying company that offers the debt does not carry the highest level of debt rating. These bonds tend to perform more like stocks in a strengthening or strong economic environment. At least for awhile, until they become "fair value" and money rotates back out.

There are times to be "in" some junk bonds and there are times to be "out." So why should you be interested in junk bond price action even though you are just an options trader? The bond market is perhaps much more complex than the stock market. The decision making process requires an extreme amount of due diligence and knowledge of the company and the economic environment now and going forward.

One way to really judge things is to compare relative strength within the bond market. Since we cant really get a good feel of relative strength by just one bond vs. one bond, I'm going to show relative strength of the AIM Intermediate Govt. Fund (AGOVX), which holds mostly U.S government securities. I want to compare that fund price strength (based on NAV) against the AIM High YIELD Fund (AMHYX), which invests in non-investment grade securities with an average credit quality of B. This was the first high yield fund established in the United States.

Relative Strength AGOVX vs. AMHYX

Wow! As you can see, the Govt. Income Fund (AGOVX) has shown incredible strength vs. the High Yield Fund (AMHYX) but perhaps that makes sense based upon what we know today about the economy. But what about the future? If this relative strength relationship tells us something about the past, then might it not tell us about the future? I sure think so.

What I've done to the above chart is lay out a retracement bracket on the RS chart range. It's kind of interesting that we actually get some correlation with RS at the retracement levels dating back to the period right around January 2001.

I've also added a "trading" strategy that a fixed income investor might have implemented based solely on RS. This plays very much into the hands of trading/investing at levels and playing the power of relative strength measurements.

Going into June 2000, an investor may have had their bond portion of the 401-k or retirement account fully invested in the High income fund (consult your financial professional to see if this would be within your risk profile). Once the RS moved above the 19.1% level, the investor may have sold 1/2 of their High Yield (AMHYX) fund and moved that money into the perceived safer Govt. Income fund (AGOVX). They didn't want to move it all there as they perhaps still weren't sure what was going on in the market and liked the higher rate of income they were receiving from the high yield fund vs. what was offered from the Govt. Income Fund. The High Yield fund had also had a very nice price performance gain while they had held it. Nonetheless, the change in relative strength was worth noting and time to take some profits and move some money to safety.

Then in October of 2000, relative strength continued to climb as the Govt. Income fund (AGOVX) was outperforming the High YIELD fund (AMHYX). An additional 25% of the original bond holding in the high YIELD may have been sold and that money rotated to the Govt. Income Fund.

In November of 2000, the further strength of the Govt. Income fund (AGOVX) was really starting to overtake the performance of the High Yield fund (AMHYX) and the remaining amount of capital was rotated to the perceived safety.

Only a break of a level of retracement would the investor rotate money back to the High Yield fund (AMHYX).

Well... here we are. The past four sessions, we've seen some impressive selling in the Treasury bond fund and I've seen some Net Asset Value (NAV) price decline in the AIM Intermed. Govt Fund (AGOVX) and some price strength in the AIM High Yield Fund (AMHYX).

Why would "junk bonds" be showing price appreciation? Is the market out of its mind? Doesn't it know that we're most likely in the midst of a recession?

Hmmmm.... but if we think back to June of 2000, everything was rosey as I remember. Why was the market opting to sell junk bonds and buy Govt. Treasury bonds? Was it because the bond market knew something the stock market had yet to figure out?

On the right side of the retracement brackets, I've now put together an investment plan going forward, but also a plan that we as option traders might use to understand the bond MARKET's view on things going forward.

At the bottom of retracement, we were willing to sell 50% High Yield (AMHYX) and buy 50% Govt. (AGOVX). The reason we were willing to do this is that we wanted to SELL RISK!

Now we look to be near the top. But! And this is the BIG but. I don't want to buy a lot of RISK right now. Remember, we're in what looks to be a recession. If I load up on junk bonds (AMHYX) and the economy doesn't pull out of things, we're going to be stuck holding too much risk! What I want to do is dip my toe in the water. Then if I have success I will add further to the exposure of junk bonds.

As stock/option traders, we can learn from the dynamics that take place in the bond market. We can get a better feel for what very smart money thinks about the economy going forward.

I think the bond market did a very good job of figuring things out back in June of 2000 don't you?

Monitor both markets

In the past two years, I've talked a lot about the bond market and how it can be a stock investor's best friend. There's trillions of dollars in the bond market. Sometimes it just rotates within the bond market, but some money also comes out and rotates to stocks.

As "risky" as a junk bond may seem, a "junk bond" on company ABCDEF is actually "safer" than the stock of ABCDEF. The reason being is that the bond is an OBLIGATION to pay a stated rate of interest and then return original principle back to the investor. While there are no guarantees of either, it is still an OBLIGATION, something a stock does not carry.

Jeff Bailey
Senior Market Technician
Option Investor

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