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Paul Cunningham Of Merit Advisors

05/25/05 12:36:36 PM PST
by David Penn

Like a little "junk in the trunk"? More speculators are looking to high-yield bonds — and high-yield bond market timers — for trend trading opportunities.

When asked what he thinks is the biggest misconception about high-yield or "junk" bonds, Paul Cunningham — principal with Merit Advisors, a firm that market times the junk bond market — replies without hesitation: "That they'll only lose you money."

Cunningham, who has been in the financial game since getting his mutual fund license way back in 1959, is hardly naive about the impression that the average investor — even the average, knowledgeable investor — has about the high-yield bond market. Too many people, he says, "take the label 'junk' literally." Indeed, in a world in which the two biggest automakers in the United States — General Motors and Ford — have seen their corporate debt reduced to junk status by the Standard & Poor's rating service, there is little surprise that many simply don't know how literally to take the phrase "junk bond."

Good ways for traders to follow the high-yield bond market include Lipper's widely followed index (which is available by subscription only), as well as the Merrill Lynch high-yield index, which is published regularly in The Wall Street Journal. Cunningham also encourages investors to track individual high-yield bond funds to get a sense of how the high-yield bond market moves.

Moves? That's right. On the one hand, Cunningham counters the popular misconception that high-yield bond investing is a one-way ticket to the poorhouse, noting that "on a buy and hold basis, you'll [tend to] have a positive total return." On the other hand, Cunningham and the clients he serves through Merit Advisors are not especially interested in sticking around during those times when the high-yield bond market is underperforming.

When it comes to high-yield or junk bonds, Cunningham treats them the same way that countless stock, commodity and foreign exchange traders treat their vehicles. To wit, Cunningham and Merit Advisors actually deploy a trend-following system that they say works "especially well" with high-yield bonds. "If you chart the daily price of the typical [high-yield bond] fund," he explains, "you'll see hills and valleys, rallies and pullbacks."

One surprise, according to Cunningham, is that junk bonds feature "much smoother price curves than stocks."

Cunningham hints that there are a few other timers, particularly trend-followers, who follow the high-yield bond market — some with methods as straightforward as 25-day moving averages as signal generators. He is quick to add, however, that "we don't use that indicator, but some people do."

The back-testing work for Cunningham's proprietary high-yield bond market trading system was done back in 1985 and 1986 during the golden era of junk bonds, courtesy of traders like Michael Milken, whose name became synonymous with the junk bond market for a few heady years during the 1980s (even though the phrase had been around since the 1970s, says Cunningham). That said, "The rules we use today are the rules we used then. An occasional whipsaw then, an occasional whipsaw now," he opines.

In terms of actually managing investor money based on the signals provided by his market timing system, Cunningham says he uses two different approaches. On the long side, a buy signal tells him to commit funds to any one of the junk bond mutual funds he and his research team track. On the short side, however, there are two options: Plan A and Plan B. Plan A means that when the system provides a sell signal, Cunningham moves to cash. Plan B, on the other hand, is another matter and has an fascinating genesis.

"When yields on money markets got so pitifully low," Cunningham says, that's when he decided to look into the option of trading long/short funds that are tied to the long Treasury bond. Examples of such funds include the Rydex Government Bond and Juno funds. The Juno fund sports an ­1 beta to the long bond.

Historically, Cunningham points out, "Our high-yield investments have been on for about 55% of the time, the rest of the time in cash equivalents." This was largely out of an exceptional aversion to drawdowns. What is now considered Plan B is a helpful response that allows Cunningham and his clients to take advantage of the same sort of trending patterns on the downside as they do on the upside.

Asked about the eternal foil of trend trading — the giveback problem that keeps trend traders from selling at the high or covering shorts at the low — Cunningham doesn't hesitate to admit being a mere trend-following mortal. "We're not totally successful," he says. But between his use of trailing stops and what he says is a "feature that allows us to occasionally... generate a sell right near the top," Cunningham suggests that his trend-following approach suffers no worse than others from giveback — and might even come out better than many.

He adds: "We also have a rule we apply in case of a bad signal. We have a technique that forces us to reverse our position."

So what has kept Cunningham a market-timer for so long? Has he always believed in the market-timing gospel? Cunningham's relationship with numbers — if not dollars — goes back to his days as a high school math teacher in the 1950s, a pasture he left for the "greener fields" of the stock market. In those early days, Cunningham recalls, life in the securities business was a lot different from life in the classroom. "If I produced, I ate," he recalls. "If I didn't, I got lean."

In those days, like a great many young brokers of his era, Cunningham was schooled in fundamental analysis. Actually, "schooled" is an interesting way of putting it. As he says, after working his way up to branch manager of a local New York Stock Exchange (NYSE) firm, Cunningham became disillusioned with fundamental analysis and its shortcomings, particularly when those shortcomings came courtesy of his firm's own research department. "I got tired of rebuilding my book of clients," he reflects with a chuckle. It sounded like the same old story: a combination of fundamental analysis and a commissions-first attitude.

In 1985, Cunningham says he just "happened on" to the high-yield bond market, and it was his sense of the tremendous opportunity and risk in that market that brought him closer to technical analysis. He began looking back at earlier high-yield bond fund prices and saw a trending tendency. "I just wonder[ed] if you could find a mechanical way to trade in and out of this type of fund," he explains.

Knowing that he would need something that would be "lasting" for his clients, Cunningham says he didn't know whether his "trending tendency" would work. But he was nonetheless drawn to develop something from his insights. He began practicing his ideas using his own account at first. But by the summer of 1987, he was convinced he had discovered something reliable.

Just what was that something? For one thing, Cunningham may be among those few bond fund traders whose ears aren't permanently bent in the direction of the Federal Reserve. "Our method," Cunningham says, "doesn't require us to guess where interest rates are headed. It doesn't matter what the chair of the Fed is saying. For what we're doing, it really doesn't matter." Cunningham has a similar technician's distaste for the financial news media, saying that watching your favorite financial news network is unnecessary.

Unfortunately, average investors, Cunningham says, "are going to do this anyway." The media, he notes, is just looking for a story. And what they end up with is usually 50% news and 50% entertainment, but 100% guaranteed to "put your investment program at risk." The only sure footing for a technician or investor or "anyone who follows the market is to have a set of rules and guidelines," he explains. After that, there are only two things left: the rules have to be reliable in order to work and the trader must have the temperament in order to follow them. "When you see a signal," Cunningham warns, "[you've got to] call it and act on it promptly."

"Stick to whatever your model calls for," he adds. "Back when I was using my gut feeling, it nearly always cost my clients money."

Fortunately for Paul Cunningham and his clients at Merit Advisors, those days of gut feelings and second-guessing are long gone. Instead, they've been replaced by a man who, at the age of 77, clearly still gets a charge out of navigating his clients through the tricky waters of financial investment and speculation, a man who can say "I love what I do" even after all the ups and downs of the market in recent years. But recent years or not, Cunningham's attitude toward the market has remained as reliable as the trend-following method he has followed faithfully for years.

"All you need is daily fund prices and our rules," says Cunningham, with words that swell the chest of every market technician with pride. "If you and I are looking at the same charts and you have our rules, then we'll see a buy at the same time and a sell at the same time." And if the times that lie ahead are anything like the times Cunningham and his clients at Merit Advisors have seen in recent years, then more power to the market-timing of high yield bonds. And bring on the junk!

David Penn may be reached at

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David Penn

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