Investors should diversify across many ‘asset classes’. One of these asset classes, of course, is fixed-income investments, like bonds. The trouble is, with interest rates so low (even on long-term bonds), bond investing holds little appeal for most investors.
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 rated below investment grade by credit-rating agencies. Moody’s Investors Services, for example, rates these corporate bonds at less than BBB- (provided they’re rated at all). Rating agencies Standard & Poor’s and Dominion Bond Rating Service have similar rating systems.
In fairness, not all junk bonds are junk. Some small firms, for example, are creditworthy. But because they’re small, the bond-rating agencies might give them below-investment-grade credit ratings.
Junk bonds are often very good bonds to investment in. Typically, they’re much more profitable than ‘investment grade’ corporate bonds. For instance, Salomon Brothers’ ‘high-yield’ bond index showed returns of 403 per cent from 1980 to 1992. This period includes the recession of 1990, when defaults on bonds increased significantly. Over the same dozen years, U.S. government bonds rose by only 312.4 per cent, U.S. investment-grade corporate bonds by 357.9 per cent, and mortgages, by 372.2 per cent. Junk bonds continue to outperform.
Junk bonds are similar to stocks
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.
The prices of investment-grade bonds, the best bond investments, 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 a change in the financial condition of the company that issued the bonds. If the issuing company improves, its junk bond can rise sharply in price and produce big gains. That’s because of the rising likelihood that the company will continue to pay the interest on its debt and repay the debt itself. 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 issuing company improves.
How to invest 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 the company failures are often concentrated in problem industries. A good example is technology stocks in the early 2000s.
In order to diversify properly, we recommend that 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 U.S. bonds. That’s because the U.S. junk bond market is the largest in the world. This means that 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, safe bonds to invest in like those 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 can offer a roller-coaster ride. A bad year for junk bonds, for example, was in the recession year of 1990. A record US$17.8 billion in defaults caused junk bonds to lose seven per cent. Then, in 1991, a good year, junk bonds soared 41 per cent.
To profit, therefore, you should buy a mutual fund that specializes in junk bonds and can diversify your holdings.
The Investment Reporter, MPL Communications Inc.
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