If this article were a movie, then it would be rated "M" for
mature. This investment isn't for the faint of heart.
But if you can stomach a little volatility in search of higher
yields, then I would be remiss if I didn't bring your attention to
this opportunity. With these securities, yields of 10% or more
aren't just common, they're often expected.
What investment am I talking about?
Junk bonds, but more specifically, junk-bond funds.
Junk bonds are corporate
that are rated below "
" (BBB- on the Standard & Poor's rating scale). But don't let
the "junk" in their name fool you. Though riskier than
investment-grade bonds, junk bonds can still offer a good
high-yield opportunity with low-default rates.
I last suggested junk bonds about two years ago, when I added
Barclays Capital High Yield Bond (NYSE:
"10%-Plus" model portfolio.
At the time, the investment was a no-brainer. This exchange traded
) was yielding 12.8%. Corporate default rates -- a key driver of
junk-bond prices -- were rapidly declining as the
yields were trading at a huge 9% premium to Treasury yields
(meaning the spread between similar Treasury yields and these bonds
was nine percentage points).
The historic average for the
and these high-yield bonds is close to 6%. If the spread is above
that, then junk bonds are considered cheap.
Subscribers and I were rewarded for taking the risk. In about two
years, we've received $7.87 per share in distributions. Although
JNK has pulled back slightly from a recent peak of $41 this May,
we've still enjoyed total returns of over 25%.
So naturally, I've been looking for a good time to add more
junk-bond exposure to my portfolio. But by February of this year,
the spread between these bonds and Treasuries was hovering about
4.5% -- a little on the pricey side.
But thanks to an S&P credit
of the United States and a European debt crisis, the landscape for
these high-yielders has shifted.
As the market sold off, risk-averse investors pulled their money
out of junk bonds and junk bond funds. That's put all types of
these securities on sale, pushing the yield spread above 7%.
Now that junk bonds are affordable, I think it's reasonable to
believe investors will return to these high-yielding investments.
For one reason, investors are starved for higher yields.
An ironic consequence of the S&P's ratings cut was that
investors stampeded into the recently downgraded Treasuries for
safety, causing the yields on these assets to plummet.
Five-year Treasuries are currently yielding a paltry 0.9%.
Meanwhile, 5-year "AAA" corporate bonds aren't any more appealing,
yielding slightly more than 1.3%. When the panic abates, investors
could return to the junk bond arena, desperate for higher yields.
But higher yields aren't the only allure.
Right now, corporations are sitting on piles of cash, a good sign
. During the peak of the credit crisis in November 2009, the U.S.
junk-bond default rate peaked at 13.7%. But by July 2011, corporate
default rates were near 1.3%. That's well below the long-term 5.1%
And despite the recent financial panic, default rates are predicted
to stay down. "Corporate default counts have remained low,
consistent with our recent expectations, and under our baseline
economic scenario of slow recovery, we expect that trend to
continue," says Moody's director of credit policy Albert Metz.
Therefore, assuming corporate default rates stay low, the economic
back-drop bodes well for a rebound in this sector.
Like I said, junk bonds aren't for everyone. There's an element of
risk that naturally comes with investing in a speculative
Action to Take -->
But looking forward, the market for junk bonds looks strong. And if
the current environment has you hunting for higher yields, then
these securities could be just the thing.
-- Carla Pasternak
P.S. -- In my last issue of High-Yield Investing, I talked more
about junk bonds and suggested two high-yield bond funds yielding
10.4% and 11.1%, respectively. To learn more about this advisory,
which is enjoyed by nearly 40,000 subscribers, I invite you to
watch this presentation...
Disclosure: Neither Carla Pasternak nor StreetAuthority, LLC
hold positions in any securities mentioned in this article.
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