Monday, March 10, 2014

Why Junk Bond "Recycling"?

Some blog readers without a background in technical analysis of securities may wonder why the blog is named "Junk Bond Recycling". The name is based on the observation that technical analysis of time-series price data displayed in chart form can define various cycles or patterns that allow an investor to buy low and sell high and then repeat this action again and again through time. Hence the security, in most cases for our purposes, a mutual fund that holds a multitude of high yield bonds, is "recycled".

So recycling really is just another way of saying that the security is traded based on the technical analysis and interpretation of technical data, with the objective of buying at a so-called "bottom" and selling at a so-called "top" (i.e., buy low and sell high).

Built into our technical analysis and investment process are: 1) The goal of minimizing transactions to several per year - this partly depends on how successfully the data are interpreted and whether or not there are false buy and or sell signals; and 2) The goal of minimizing a loss to a fraction of a percent if an incorrect buy decision is made, perhaps due to a false signal, that requires a sell action soon after the buy is initiated for protection from capital loss.

The chart below shows a very simple example, which includes the 2008-9 crash, where an exponential moving average (ema) is used to analyze a chart for a corporate high yield bond mutual fund. The 30-day ema was chosen based on a trial-and-error curve fitting process with the goals above in mind.

Normally, we use more than one line of evidence (i.e., we use several technical indicators, not just the ema) to support a decision to buy (or sell) to provide more confidence in our investment decisions. In addition to simple and exponential moving averages, which may have their limitations during markets that move sideways, these lines of evidence almost always include technical indicators that define overbought or oversold conditions, and support and/or resistance lines.

(click chart to enlarge)
Corporate High Yield Bond Mutual Fund with 30-day Exponential Moving Average
Settings: daily | semi-log | mid-2006 to mid-2009)

When conducting technical analysis on time-series data to define actionable chart patterns, it is assumed that the "past is the key to the present." Note this is much different than the disclaimer in many prospectuses that "past performance may not be indicative of future results." Why?  Because as stated, the former refers to price data and chart patterns while the latter refers to performance information. If an investor bases a decision to buy a security because its 1yr | 3yr | 5yr year returns are say 20 | 40 | 65 percent, for example, this investor could be buying at the top of a cycle and experience significant capital losses in short order.

In contrast, buying at a price support level (an apparent price bottom within a cycle defined through technical analysis of time-series data) provides a relatively safe entry point because if the security's price moves below the support level, normally it can be sold before any significant (unrecoverable or permanent) capital loss occurs; then, the patient investor simply waits for another opportunity in the future.  This methodology reduces risk management to a simple if/then statement (i.e., hold the security if the price remains above the support level, and sell if it moves below the support level). If the security's price stays above the support level, risk management becomes profit management. Continued technical analysis as the security is held, allows an investor to determine when to sell and harvest profits. For example, selling a security could occur when the price eventually moves below a higher support level, or the price concurrently encounters a significant long-term resistance level and overbought conditions.

Back to the chart above.  One can see, with less than a few exceptions, that buying just after the security's price (green line) crosses above the 30-day ema (blue line), using the 30-day ema as a moving support level (line), and then selling when the security's price crosses below the 30-day ema, would have allowed an investor buy low and sell high. The investor would have been protected from all the significant downturns while realizing substantial capital gains and many months worth of dividend payments, resulting in a high total return for the time period.

Tracing the various trades from left to right across the chart (see corresponding numbers on annotated on chart below), the investor would have: 1) Participated in the rally in 2006 to mid-2007 (includes some false buy/sell signals); 2) Sold before the downturn started in mid-2007, while still participating in two short-term counter-trend rallies (2a and 2b) in late 2007 and early 2008; 3) Sold before the crash started in mid-to-late 2008; 4) Participated in the short-term "Santa Claus" rally at the end of 2008 into early 2009; and 5) Participated in the huge rally extending through 2009.

(click chart to enlarge)
Corporate High Yield Bond Mutual Fund with 30-day Exponential Moving Average
Settings: daily | semi-log | mid-2006 to mid-2009)

Not Investment Advice | Important Disclaimer: 
The content in this article, including the identification and discussion of any specific security (e.g., bond fund), is NOT meant to be and should NOT be construed and/or used as investment advice. This article is for general information and educational purposes only. Please read the Disclaimers  for in their entirety. The U.S. Securities and Exchange Commission website has guidance on selecting an investment adviser.

Financial Disclosure:
The author/publisher owns shares of several corporate high yield bond mutual funds. 

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