The key to making money with junk bonds is to diversify across industries. That’s because failing companies are often concentrated in problem industries.
Investors should diversify across many ‘asset classes’. One of these asset classes, of course, is fixed-income investments, such as bonds. The trouble is, with interest rates so low or even negative on foreign long-term bonds, they hold little appeal for most investors.
Recently, we’ve heard observers say that the solution to low interest rates is to buy junk bonds (also referred to by the better-sounding term ‘high-yield’ bonds). Junk bonds are company bonds that are rated below investment grade by credit-rating agencies. Moody’s Investors Service, for example, rates these corporate bonds at less than BBB- (provided they’re rated at all). Rating agencies such as Standard & Poor’s and Fitch Ratings have similar rating systems.
In fairness, not all junk bonds are junk. Some small firms, for example, are very creditworthy. But because they’re small, the bond-rating agencies often give them below-investment-grade credit ratings.
Junk bonds are often very profitable
Junk bonds are often very profitable investments. Typically, they’re much more profitable than ‘investment grade’ corporate bonds. The only time junk bonds are less profitable is during financial crises or recessions. At that point, companies with too much debt can default or go bankrupt.
The only thing is, junk bonds behave more like stocks than they do bonds. As a result, they do little to diversify your portfolio by asset class. Contrary to popular belief, buying junk bonds doesn’t increase the percentage of fixed-income holdings in your portfolio. Instead, it effectively increases the percentage in stocks.
Junk bonds march to their own beat
The prices of investment-grade bonds, of course, respond mostly to interest rates. When interest rates rise, bond prices fall. When interest rates fall, by contrast, bond prices rise.
Junk bonds, however, respond little to changes in interest rates or the typically higher interest rates they pay. What matters most to a junk bond’s price is changes in the financial conditions of the company that issued the bonds. If the issuing company improves, its junk bond can rise dramatically in price and produce big capital gains. That’s because of the rising likelihood that the company will continue to pay the high interest rates on its debt. The fact is, junk bonds trade more on a company’s credit-worthiness as opposed to the level of interest rates. This is similar to stocks which can also soar if the company that issued the shares improves.
In short, you might decide to profit with junk bonds. Just remember that instead of increasing the proportion of fixed-income investments, you’re actually increasing your stock-like investments.
Profiting in junk bonds
The key to making money with junk bonds is to diversify. Obviously, you should limit your exposure to any given company. Less obvious is the need to diversify across industries. That’s because failing companies are often concentrated in problem industries. A good example is oil and gas service companies since the oil prices plunged.
In order to diversify properly, we recommend you buy units in a mutual fund that, in turn, buys junk bonds. It’s better to buy a mutual fund that holds lots of US bonds. That’s because the US junk bond market is the largest in the world. This means you can diversify by company and industry.
The Canadian market lacks this diversity. For one thing, many of our important industries are tied to resources, with commodity prices that rise and fall at the same time, based on the strength of the world economy. For another, bonds issued by other important industries like banking aren’t, of course, junk bonds.
You must also have a high tolerance for risk. That’s because junk bonds offer a roller-coaster ride. A bad year for junk bonds, for example, was in the recession of 1990. A record US$17.8 billion in defaults caused junk bonds to lose seven per cent. Then, the next year, junk bonds soared 41 per cent.
To profit, therefore, you should buy a mutual fund that specializes in junk bonds. You’ll also need nerves of steel.
This is an edited version of an article that was originally published for subscribers in the November 1, 2019, issue of The Investment Reporter. You can profit from the award-winning advice subscribers receive regularly in The Investment Reporter.
The Investment Reporter, MPL Communications Inc.
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