Garbage Collectors

Junk bonds shed their dirty reputation.
Magazine Contributor
7 min read

This story appears in the August 1997 issue of Entrepreneur. Subscribe »

So far, 1997 has been anything but a picnic for investors, unless you're rooting for the ants. Volatility in the stock and bond markets and unpredictable interest rate moves have made investing a party you might not want to be invited to. But if every cloud has a silver lining, every investment strategy has a secret weapon, and this one can be found at the bottom of the barrel--junk bonds.

Don't flip that page: Junk bonds have come a long way, baby. The last many investors heard about junk bonds or, as they're called in polite society, high-yield corporate bonds, might have been in connection with leveraged buyouts, corporate raiders, Drexel Burnham Lambert, the predator's ball and the infamous Michael Milken. The late 1980s and early 1990s saw the unraveling of the high-yield corporate bond market due to aggressive issuing of debt from the lowest ranks of corporate society. While millions of dollars were lost on those highly speculative issues, these bonds look as different now as Milken does without his toupee.

High-yield bonds are still subject to greater risk of loss of principal and interest than higher quality bonds; many investors avoid these securities, fearing default and spurred on by advice to put all their money in stocks. However, recent stock market ups and downs may warrant another look into the idea of diversification as the best investment policy. Diversification isn't just a mix of different investments but a combination of instruments that don't all move the same way when the market winds blow. History shows that junk bonds offer high returns relative to both stocks and bonds and, in a stock market correction, often perform better than equities. Investors in search of instruments of diversification would be well-advised to look into possibilities offered by high-yield securities.

Taking In The Trash

High-yield securities are bonds that offer historically high yields. They come in several flavors, including preferred stock, foreign government, municipal and corporate bonds. High-yield, or junk, securities are those considered to be below investment-grade quality, earning a credit rating below triple B, the lowest standard of investment-grade securities. A lower credit rating means an increased chance that the issuer may not be able to make interest and principal payments as promised. Because of the possibility that these securities may default, costing investors both interest payments and principal, the yields proffered are higher than investment-grade bonds of similar maturities.

There are two types of junk bonds: First are bonds that were issued initially as investment-grade but through their underlying firm's financial difficulties lost this high credit rating. These are called "fallen angels." The second and more common type of junk bond is a bond issued by a company that itself is of lower than investment-grade credit quality.

Robust earnings can change either type of security from junk to higher quality, resulting in potential profits for the investor. Similarly, in either situation the fate of the issuer could take an unexpected turn for the worse, leading the bond into default and the bond's owner into losses.

Sifting Through The Rubbish

You don't have to go to the bottom of the barrel to find junk bonds offering good value and high interest payments. Lars Berkman, portfolio manager of the Prudential High Yield Corporate Bond fund, suggests that today's bonds are of significantly higher credit quality than those issued during their heyday in the late '80s and early '90s. "During the recession of 1990, the default rate was 10 percent," says Berkman. "Underwriting quality was weaker in the '80s than it is today. [Price] spreads on new deals are lower, but quality is higher: The default rate is now between 1 percent and 2 percent." He believes the default rate will remain low and losses will be less common, provided the economy continues to grow.

An initial foray into high-yield investing can be daunting, and as always, don't put all your eggs in one basket. The simplest plan is to mix and match your fixed-income portfolio according to your risk tolerance. Consider investing at least half your allotted sum in high-grade Treasury bonds of intermediate maturity, yielding about 6 percent. This will keep part of the portfolio low risk, as these bonds are backed by the full faith and credit of the U.S. Treasury. The only problem is that in a stable rate environment, Treasuries tend to underperform other types of bonds. So with the other half of your fixed-income portfolio, try to increase your yield with a few high-yield corporate bonds.

Most experts recommend that small investors--in other words, those with fewer than six figures to place in any particular class of investments--stick with bond funds. While individual bonds may sound scintillating, if you select five issuers and one goes bankrupt, you could sustain a severe loss. Instead, choose a high-yield bond fund with a substantial track record that matches your objectives and goals. Remember, past performance is no guarantee of future results, and, as always, read the prospectus before you invest.

Berkman suggests different kinds of funds for different kinds of investors. For more aggressive investors, lower-grade junk bonds can provide a potentially high return but at substantially higher risk. For the more conservative, higher-grade junk bonds can provide income and diversification without betting the ranch.

Looking For Yields In All The Right Places

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.

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