One man’s junk is another man’s treasure

Or “one man’s loss becomes another man’s gain”, according to 1707’s A General Treatise of Monies and Exchanges. There are so many versions of this truism that no credit can be accurately attributed. Just always remember that your money is not junk and it shouldn’t be lost to another man’s treasury. So, how to profit in ‘junk’, or the ‘high-yield bond market’?

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 low, albeit rising, they hold little appeal for many investors.

Recently, we’ve heard observers say that the solution to low rates is to buy junk bonds (also referred to in polite company by the 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 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 investments. Typically, they’re much more profitable than investment grade corporate bonds. For instance, the Salomon Broad Investment Grade Index showed returns of 403 per cent from 1980 to 1992. This period includes the recessions in the early 1980s and early 1990s, when defaults on bonds increased significantly. Meantime, U.S. government bonds rose only 312.4 per cent, U.S. investment-grade corporate bonds 357.9 per cent, and mortgages, 372.2 per cent. Since 1992, junk bonds have continued to outperform.

Junk bonds: more like stocks than bonds

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, 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 condition of the company that issued the bond. 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 interest 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 your fixed-income investments, you’re actually increasing your stock-like investments.

How to profit 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 failure of companies are often concentrated in problem industries. A good example is ‘dot-com’ companies after 2000.

In order to diversify properly, we recommend you buy units in a mutual fund that 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 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. The worst 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, the best 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 March 17, 2017, 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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