Junk bonds

Risk versus difference in interest rate

To determine if junk bonds are a good idea, it depends on the supply and demand, as it results in in extra yield over US Treasury obligations of similar term. The reason to compare with similar term is to avoid the difference because of the interest rate risk.

Interest Rate Risk is Less Important for Junk Bond Prices

For the highest quality bonds, the biggest risks are an increase in the interest rate, resulting in a lower value of the stream of payments and therefore lower bond price, and inflation, resulting in a lower value of the dollars in the payment stream. However, for junk bonds, the risk of default may dwarf the interest rate risk and inflation risk.

Trading in junk bonds in default

Those with time and inclination to analyze bankruptcy proceedings may find some speculation opportunities. For example, if you can buy bonds at ten percent of face value, and a bankruptcy proceeding results in a thirty percent payment, that would be a high return. Needless to say, this is not a safe and steady investment strategy.

Diversification is more important

Since any one particular junk issuer can go broke, you must have diversity, and the practical way is to buy junk bonds via a junk bond fund. The largest is he Vanguard High-Yield Corporate Fund (VWEHX), with net assets exceeding $6 billion, and an annual fee of 0.28%. The Fidelity Capital & Income Fund (FAGIX) is the second-largest junk bond fund, with about $3.2 billion under management, and annual expenses of about 0.82%.

High Yield Bonds

We have a terminology issue, because the same bonds can often be referred to as junk bonds, or as high yield bonds. Perhaps the label high yield is a euphemism, as referring to a used car as pre-owned. Harmless as it does not fool anyone. Positive language may account for some terminology difference, but there is also a connotation difference. High yield explicitly refers to the yield. It may not necessarily equate to the high level of risk that we call junk. Of course, these two terms mostly go together.

History of junk bonds

Before the 1970s, the term for high yield high risk bonds was “fallen angels”, reflecting the issuer’s decline from former prosperity. In the late 1970s and thereafter, junk bonds were issued as such to begin with. Michael Milken was a major leader in popularizing junk bonds. Periods of high inflation and high interest rates that later went lower resulted in major market effects on bond investments.

In 2010, because of no confidence in stocks, many investors are allocating their capital to low interest bonds, including US Treasury obligations, and out of some desperate need for return are including more junk bonds that would have been accepted just a few years ago.

Junk Bond Funds

Note that funds that are self labeled as high yield may vary in just how much high yield and high risk is in the holdings. Some funds may hold mostly bonds with credit ratings of B or better, and this lowers the risk and the yield if you ignore the default risk. On the other hand, other funds may hold mostly bonds with credit ratings of C, giving a more exciting ride. You will want to look at the disclosure materials.

If you believe that the recession will end soon, and the now surviving companies will as a result start to have improved financial results and less risk of default, then a junk bond fund may be your choice. Because of the higher risk of default of junk bonds, junk bond funds provide much needed diversification as compared to owning a few individual junk bonds.