Everyone learns as a kid that they shouldn't play with junk. Too much risk involved - you could break your neck or poke someone's eye out, or in extreme cases, both - and let's face it, it's yucky. But we also learn at an early age that there are exceptions to every rule. As it turns out, playing with junk is no exception. If you've ever watched a young boy pick up a big stick then you know what I'm talking about. In this case, however, we are not talking about children's playthings; we are talking about junk bonds.

A long time ago, companies with questionable finances simply could not get credit. This made it difficult to expand their businesses, which pretty much lead to them continuing to have questionable finances. Then in the 1980s came the advent of the junk bond. The junk bond market enabled companies to borrow money via bond sales by offering a higher rate of interest. Investors also held the potential to benefit by purchasing these bonds and earning this higher rate of interest. And as long as the company could pay the principal and interest, everyone was a winner. Of course, there lies the rub. "Credit risk" - i.e., the ability of the borrower to pay all of the interest and principal - is a primary consideration in the junk bond market. Unlike treasury securities, which are backed by the full faith and credit of the U.S. federal government (why does that not sound quite as comforting as it used to?), junk bonds are backed only by whatever the company selling a particular junk bond happens to be.

In a booming economy the likelihood of default is much less than when the economy is struggling. In a down economy the "default rate" - i.e., the percentage of junk bonds that fail to pay interest or principal because they simply do not have the money to do so - rises. If you happen to buy a single junk bond issued by a single issuer and that company folds, you can lose your entire investment. This is why it is recommended that most investors invest in some sort of junk bond fund, so as to diversify among a number of bonds.

When things fell apart back in October 2008, the junk bond market - in fear of an economic collapse - completely fell apart and junk bonds were widely dumped ("puked" may actually be a better word) by investors without a second thought. In the process, the yield of many junk bond funds rose to 20%. Once the fear subsided a bit, investors, faced with a choice between a yield of about 0.1% on a t-bill versus 15% plus yield on junk bonds, flocked back into the junk bond market, propelling junk bond prices roughly 20% higher since December. While this is all well and good, junk bonds still remain over 25% below their previous high levels. And while there seems to be some optimism brewing regarding the economy, there are still plenty of question markets and any downward blip would likely pull the rug back out from under junk bonds.

So is there a way to play junk bonds without simply buying and hoping, er, holding? Let's take a look.

JAHYX/JAHYX Inverse

Janus High Yield fund (JAHYX) has a very high correlation to the overall junk bond market and is thus a good proxy of the junk bond market as a whole. Let's take a look at one systematic way to trade junk bonds.

Here are the calculations that we will use:

A = JAHYX daily close
B = JAHYX inverse cumulative*
C = A / B
D = Exponential 4-day moving average of C**
E = (C - D)

* as of 5/26/09 JAHYX = 7.46, JAHYX inverse = 5.1533. Inverse is updated each day by dividing yesterday's value by today's close and multiplying by yesterday's close.

** (Equals yesterday's exponential average * 0.6) + (today's JAHYX/Inverse index ratio * 0.4).

To use these calculations to trade, use the following rules:

If C > D, then buy JAHYX at tomorrow's close
IF C < D, then sell JAHYX at tomorrow's close and go to cash

Alright, now let's try it in English. We are tracking the price of JAHYX each day. We are also manually updating a "surrogate" inverse index that simply performs inversely to JAHYX. In other words, if JAHYX rises 1% today, then the inverse index declines 1% in value, and vice versa. We then divide the price of JAHYX by the price of the inverse index and recording the difference. Obviously, as JAHYX rises (and the inverse index declines), this ratio rises. Conversely, when JAHYX declines (and the inverse index therefore rises), this ratio falls.

We then keep a 4-day exponential moving average of this ratio. If the ratio is above the moving average it suggests that JAHYX is gaining strength and thus we want to be long junk bonds. Conversely, if the ratio is below the moving average it suggests that JAHYX is losing strength and thus we want to be out of junk bonds and in cash.

Chart 1 displays the price action if JAHYX and it's inverse index since January 1997. If the two lines look like mirror images it is because - duh - they are.

Chart 1 - Junk bond fund JAHYX and its inverse index

Chart 2 displays the ratio between JAHYX and its inverse index as well as the 4-day exponential moving average (although it is hard to see because it tracks so closely to the actual ratio). Note how this ratio tends to trend well over time. This is the primary characteristic that makes junk bonds a good vehicle to trade.

Chart 2 - JAYHX/Inverse JAHYX ratio plus 4-day exponential moving average

So how has this approach performed? Chart 3 displays the growth of $1,000 invested using this strategy since 1997 versus a buy and hold approach.

Chart 3 - Long/Cash Switching strategy versus buy-and-hold

A couple of performance numbers to note:

• The hypothetical average annual return for this method was about 9% versus 1.5% for a buy-and-hold approach.
• These returns include only price action and not any dividends paid. So the overall annual return over time would be significantly higher (the same holds true for the buy and hold approach).
• The system has been profitable every year while the buy and hold approach has experienced four down calendar years (including a 26% decline in 2008).
• The maximum drawdown experienced by the system was just -2.2% verus -36.2% for a buy and hold approach.

Summary

There are lots of ways to make money in the financial markets. Some investment vehicles are quite volatile and hence typically involve potentially large rewards with equally large risks. One of our jobs as investors is to learn and implement methods that may allow us to harness the upside volatility of a given vehicle while also taking steps to minimize the downside risk (it is why they put brakes on cars my friends). This article presents some food for thought regarding one volatile investment vehicle and a method for harnessing the upside while attempting to manage the downside.

Now if you'll excuse me, I have to go clean the junk out of my basement.

NOTES:

I will be teaching a session on Seasonal-based trading at this year's Optionetics OASIS, June 18-21. I look forward to seeing many of you there. For more information about this incredible event, please click here.

To learn more about Seasonal Stock Market Trend: The Definitive Guide to Calendar-Based Stock Market Investing, please click here.

To sign up for a free 1-month trial of Optionetics ETF Investor newsletter, edited by Jay Kaeppel and Clare White, you can do so by clicking here.

Jay Kaeppel
Staff Writer and Author of "Seasonal Stock Market Trends"

Optionetics.com ~ Your Options Education Site

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