Astute investors might fear the effect of rising interest rates on the value of high-yield bonds. "If interest rates are ratcheted up, junk bonds have less interest rate risk than Treasury bonds," contends Albert J. Fredman, professor of finance at California State University at Fullerton. "Junk bonds as an asset class are less risky than stocks because bonds have more security than stocks." In other words, bonds rank ahead of stocks in security of payment. Yet Fredman notes that they are similar to stocks in character. "If a company is doing well financially, recovering from losses, both its stock and junk bonds will appreciate as it recovers from a setback. The price behavior of these bonds is based on the earnings of the company," not exclusively predicated on interest rates.
In a recession, Fredman believes that Treasury bonds would outperform junk: "As corporate profits peter out, this hurts junk bonds, but declining interest rates help Treasuries," he says.
Few economists expect a recession, however. Rather, inflation seems to be the enemy of choice. From a yield perspective, only junk beats corporate bonds of investment-grade quality hands down, and they trade with much richer yields than long-term Treasury securities. Thus, in an atmosphere of high price-to-earnings, price-to-book, price-to-cash flow and price-to-dividend ratios on stocks, junk bonds can lend value to a diversified portfolio.
Junk bonds aren't for everyone, however. High-yield corporate bonds are more suitable for certain types of investors. Fredman notes that for high-income investors, high taxable interest is not tax-efficient. He recommends investing in municipal bonds to lower taxable income. But be wary of individual issues of low-quality municipal bonds. "Stick with investment-grade municipal bonds if you'll be buying individual issues with less than $100,000," Fredman says.
On the other hand, he recommends high-yield corporate bonds as part of a diversified tax-deferred account. These bonds can be part of a pension or profit-sharing plan, adding stability to a portfolio where people are afraid of a correction. The same goes for Individual Retirement Accounts and Simplified Employee Pension Plans, but consult your financial advisor for the best mix for your situation.
Lorayne Fiorillo is a financial advisor at Prudential Securities in Charlotte, North Carolina. For a free copy of her Investment Planning for Women newsletter, send a self-addressed, stamped envelope to her in care of Entrepreneur, 2392 Morse Ave., Irvine, CA 92614.