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So far, 1997 has been anything but a picnic for investors,unless you're rooting for the ants. Volatility in the stock andbond markets and unpredictable interest rate moves have madeinvesting a party you might not want to be invited to. But if everycloud has a silver lining, every investment strategy has a secretweapon, and this one can be found at the bottom of the barrel--junkbonds.
Don't flip that page: Junk bonds have come a long way, baby.The last many investors heard about junk bonds or, as they'recalled in polite society, high-yield corporate bonds, might havebeen in connection with leveraged buyouts, corporate raiders,Drexel Burnham Lambert, the predator's ball and the infamousMichael Milken. The late 1980s and early 1990s saw the unravelingof the high-yield corporate bond market due to aggressive issuingof debt from the lowest ranks of corporate society. While millionsof dollars were lost on those highly speculative issues, thesebonds look as different now as Milken does without his toupee.
High-yield bonds are still subject to greater risk of loss ofprincipal and interest than higher quality bonds; many investorsavoid these securities, fearing default and spurred on by advice toput all their money in stocks. However, recent stock market ups anddowns may warrant another look into the idea of diversification asthe best investment policy. Diversification isn't just a mix ofdifferent investments but a combination of instruments thatdon't all move the same way when the market winds blow. Historyshows that junk bonds offer high returns relative to both stocksand bonds and, in a stock market correction, often perform betterthan equities. Investors in search of instruments ofdiversification would be well-advised to look into possibilitiesoffered by high-yield securities.
Taking In The Trash
High-yield securities are bonds that offer historically highyields. They come in several flavors, including preferred stock,foreign government, municipal and corporate bonds. High-yield, orjunk, securities are those considered to be below investment-gradequality, earning a credit rating below triple B, the loweststandard of investment-grade securities. A lower credit ratingmeans an increased chance that the issuer may not be able to makeinterest and principal payments as promised. Because of thepossibility that these securities may default, costing investorsboth interest payments and principal, the yields proffered arehigher than investment-grade bonds of similar maturities.
There are two types of junk bonds: First are bonds that wereissued initially as investment-grade but through their underlyingfirm's financial difficulties lost this high credit rating.These are called "fallen angels." The second and morecommon type of junk bond is a bond issued by a company that itselfis of lower than investment-grade credit quality.
Robust earnings can change either type of security from junk tohigher quality, resulting in potential profits for the investor.Similarly, in either situation the fate of the issuer could take anunexpected turn for the worse, leading the bond into default andthe bond's owner into losses.
Sifting Through The Rubbish
You don't have to go to the bottom of the barrel to findjunk bonds offering good value and high interest payments. LarsBerkman, portfolio manager of the Prudential High Yield CorporateBond fund, suggests that today's bonds are of significantlyhigher credit quality than those issued during their heyday in thelate '80s and early '90s. "During the recession of1990, the default rate was 10 percent," says Berkman."Underwriting quality was weaker in the '80s than it istoday. [Price] spreads on new deals are lower, but quality ishigher: The default rate is now between 1 percent and 2percent." He believes the default rate will remain low andlosses will be less common, provided the economy continues togrow.
An initial foray into high-yield investing can be daunting, andas always, don't put all your eggs in one basket. The simplestplan is to mix and match your fixed-income portfolio according toyour risk tolerance. Consider investing at least half your allottedsum in high-grade Treasury bonds of intermediate maturity, yieldingabout 6 percent. This will keep part of the portfolio low risk, asthese 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 theother half of your fixed-income portfolio, try to increase youryield 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 classof investments--stick with bond funds. While individual bonds maysound scintillating, if you select five issuers and one goesbankrupt, you could sustain a severe loss. Instead, choose ahigh-yield bond fund with a substantial track record that matchesyour objectives and goals. Remember, past performance is noguarantee of future results, and, as always, read the prospectusbefore you invest.
Berkman suggests different kinds of funds for different kinds ofinvestors. For more aggressive investors, lower-grade junk bondscan provide a potentially high return but at substantially higherrisk. For the more conservative, higher-grade junk bonds canprovide income and diversification without betting the ranch.
Looking For Yields In All The Right Places
Astute investors might fear the effect of rising interest rateson the value of high-yield bonds. "If interest rates areratcheted up, junk bonds have less interest rate risk than Treasurybonds," contends Albert J. Fredman, professor of finance atCalifornia State University at Fullerton. "Junk bonds as anasset class are less risky than stocks because bonds have moresecurity than stocks." In other words, bonds rank ahead ofstocks in security of payment. Yet Fredman notes that they aresimilar to stocks in character. "If a company is doing wellfinancially, recovering from losses, both its stock and junk bondswill appreciate as it recovers from a setback. The price behaviorof these bonds is based on the earnings of the company," notexclusively predicated on interest rates.
In a recession, Fredman believes that Treasury bonds wouldoutperform junk: "As corporate profits peter out, this hurtsjunk bonds, but declining interest rates help Treasuries," hesays.
Few economists expect a recession, however. Rather, inflationseems to be the enemy of choice. From a yield perspective, onlyjunk beats corporate bonds of investment-grade quality hands down,and they trade with much richer yields than long-term Treasurysecurities. Thus, in an atmosphere of high price-to-earnings,price-to-book, price-to-cash flow and price-to-dividend ratios onstocks, junk bonds can lend value to a diversified portfolio.
Junk bonds aren't for everyone, however. High-yieldcorporate bonds are more suitable for certain types of investors.Fredman notes that for high-income investors, high taxable interestis not tax-efficient. He recommends investing in municipal bonds tolower taxable income. But be wary of individual issues oflow-quality municipal bonds. "Stick with investment-grademunicipal bonds if you'll be buying individual issues with lessthan $100,000," Fredman says.
On the other hand, he recommends high-yield corporate bonds aspart of a diversified tax-deferred account. These bonds can be partof a pension or profit-sharing plan, adding stability to aportfolio where people are afraid of a correction. The same goesfor Individual Retirement Accounts and Simplified Employee PensionPlans, but consult your financial advisor for the best mix for yoursituation.
Lorayne Fiorillo is a financial advisor at PrudentialSecurities in Charlotte, North Carolina. For a free copy of herInvestment Planning for Women newsletter, send a self-addressed,stamped envelope to her in care of Entrepreneur, 2392 MorseAve., Irvine, CA 92614.
