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Stocks have been on a tear the past few months, no doubt
about it.
With a +54%
gain since bottoming March 6th and a +13.4%
gain year-to-date, investors would have done pretty well to
simply buy into the S&P at the start of the year.
Of course, that's only if they didn't mind missing out on
triple that return and historically high
yields.
It's true. The typically "shunned" securities I've found
have walloped stocks this year -- returning
+38.6% on
average from the start of the year through mid-August -- and their yields
peaked at a record 21.8% just a few months ago.
Meanwhile, in at least one key way these assets are safer
than any stock. If you own them and the issuing company goes
into bankruptcy or liquidation, you are higher on the
payment pecking order than any common or preferred
shareholder.
But despite their strong rise this year... despite their
potential safety compared to stocks... and despite their
sky-high yields... most investors still avoid this asset
class like the plague.
You see, too many people are tripped up by the name "junk
bonds." The name makes the bonds sound like something you
put in the blue recycling bin. But you shouldn't be scared
away, especially if you're looking for double-digit yields
in today's market.
The Most Lucrative Time to Invest
Simply put, junk bonds are any bonds rated "BB+"
and lower by S&P or "Ba1" and lower by Moody's. These bonds generally rise
and fall with the fortunes of the economy, since that's the
biggest factor as to whether the parent company can cover
the bond obligation.
Investors tend to dump junk bonds during economic downturns
since they're less likely to be paid back. The result is
depressed prices and high yields. During economic recoveries the
bonds tend to rise as the risk of default lessens and
investors move to lock in the high yields.
It's the period after an economic downturn and before the
recovery that is usually the most lucrative time to invest
in junk bonds.
We seem to be in that period right now.
The credit crisis pushed default rates on U.S. junk bonds to
a six-year high of 11.5% in July, up from a mere 2.7% in
July 2008, according to Moody's. The rating agency predicts
the U.S. speculative-grade default rates will peak in the
fourth quarter this year at 12.7%.
The rapid rise in defaults led investors to dump the bonds
with abandon. Junk bonds bottomed in mid-December as fears
of rising defaults sent yields to a record 21.8%.
But fears about the severity of the Great Recession have
abated, and yields have declined as prices have
risen. Between October 2008 and April 2009, yields held
stubbornly above 15% as judged by the Merrill Lynch
High-Yield Master II Index. They're now moving lower again, but
the sector still yields an average of
11.7% as of late August.
Despite the improvement in the outlook for junk bonds, they
still have room to run. The spread between junk bonds and
Treasuries is still historically high. For the last few
years, investors were satisfied with spreads of between 2%
and 4%. As of two weeks ago that spread was about 9%. And with
junk bonds still selling at roughly 80% instead of the
historic 90% of par value, prices can rise as well.
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There's always the risk we could slide back into recession,
which would hurt the bonds,
but it's likely the worst has passed. Many pundits,
including Alan Greenspan and Ben Bernanke, share this
outlook, although the potential for a strong recovery isn't
clear. This lack of clarity is why the opportunity in junk
bonds still exists today, even though Moody's expects
default rates in the U.S. to retreat to 3.8% by this time
next year.
If you can avoid being scared off by the name, I think junk
bonds offer one of the most attractive opportunities around
for income investors.
One thing to note: With junk bonds, diversification across
companies and industries is crucial, and it's best achieved
with ETFs, CEFs or mutual funds. They may not throw off
yields as high as some individual bonds, but being able to
purchase a stake in dozens of bonds at once is a necessity,
especially until there's a clearer sense of a strong
economic rebound.
Good Investing!
Carla Pasternak's Dividend Opportunities
P.S. -- I can't
stress enough how important it is to invest in junk bonds
via a fund. If you hold one bond and it defaults,
your investment will be in trouble. With a fund, you have
instant diversification. I brought my
High-Yield
Investing readers nine junk bond funds in my
September issue. My favorite yields a solid 12.8%. To join
now and get the names of these funds, please
visit this
link.
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