Should I start with a junk in the trunk reference, or point out that the term junk is also a slang word for male genitalia? Decisions, decisions.
As I’ve explained before, y’all gotta get yourself some bonds. They serve a couple of purposes. First, they tend to go up when CRAZY TWEETING PSYCHOPATHS LIKE DONALD TRUMP make stocks crash. SMDH, he’s already ruining America.
Wait. I’m being told that didn’t happen. Well. That’s surprising.
When stocks crash, that’s usually a good buying opportunity. Since most people are fully invested (or at least should be, since opportunity costs are a very real thing), they don’t have a ready cash source available when it’s time to start buying. That’s where bonds come in. You sell them and buy equities.
There’s just one problem with bonds today. They don’t offer much in yield. Canada’s biggest bond ETF (the iShares bond universe index fund, ticker TSX:XBB) pays less than 3% annually. That’s not bad when compared to a GIC, but it’s not very exciting. I NEED A RUSH BABY YOU GUYS GOT ANY METH?
There are other bond sources that pay much higher yields. Let’s take a closer look at junk bonds, the perfect thing to sexy up your fixed income portfolio.
What are junk bonds?
Junk bonds sound bad, Nelson. Real bad. I don’t care for things that are bad.
Thanks for helping out, Italics Man.
Junk bonds (or high-yield bonds if you’re being paid by someone who peddles such things) are debt instruments issued by riskier companies. The bond risk hierarchy goes something like this:
- Mortgages and other things backed by the government
- Provincial/State governments
- High-quality corporate debt
- Medium-quality corporate debt
- Countries ran by dictators or Greece
- Terrible corporations
- Your friend Steve
When interest rates were higher, the spreads between the best risks and the worst risks was in the neighborhood of 5-20%. That spread has tightened somewhat. A government can get short-term money for 1%. Most junk bonds don’t pay any higher than 8%.
Junk bonds don’t really behave like regular bonds. Most bonds go up and down based on two factors — interest rates and the direction of stocks. Often these two things go hand in hand. So if stocks fall, that means rates will fall with them. Bonds will then go up. The opposite happens when stocks rise. Junk bonds do follow interest rates, but they also react alongside stocks. They’re much more sensitive to the overall health of the underlying company.
Look at it this way. Microsoft is one of the safest bets in the corporate bond world. It’s going to pay back its debt no matter what. Things are much dicier for a company like Teck Resources. It needs a halfways decent economy.
How to invest in junk bonds?
Let’s focus with the two easy ways, which are through ETFs or closed-end funds. You can also buy individual junk bonds, but if you could do that you’d probably be reading smarter stuff than this crap.
There are a metric assload of junk bond ETFs out there, all with their own unique spin on the world but with only the smallest of differences. Hey, just like personal finance blogs!
Oh, that’s gonna get him punched.
The biggest junk bond ETF is the SPDR Barclays Capital High Yield Bond ETF, which has a very appropriate ticker of JNK on the New York Stock Exchange. It holds 811 different bonds that have an average yield to maturity of around four years. It pays out a dividend of 6.1%.
The junk bond world in Canada is much smaller than in the U.S., so we’re pretty much stuck investing there. But there are quasi-Canadian ETFs that at least trade on the Toronto Stock Exchange. BMO has a U.S. junk bond ETF that’s hedged to Canadian Dollars (TSX:ZHY), that pays 6.1% and has an average of about four years maturity left. But it only holds 463 different bonds like a chump and/or chumpette.
I don’t own any of these ETFs. Instead, I use a closed-end fund to get exposure to the sector. I even pay a management fee of (gasp!!!) greater than 1% to do so.
I own the Dreyfus High Yield Strategies Fund (NYSE:DHF) which uses leverage to enhance junk bond returns. In a nutshell it takes a dollar, borrows an additional thirty cents, and invests the $1.30 in a couple hundred junk bonds. Because it can borrow at good rates, this gooses my yield in exchange for a little more volatility. I’m quite okay with this trade-off.
My Dreyfus closed-end fund yields 9.8% versus 6.1%, which is what a comparable ETF pays. If we’re looking for income, that’s good.
I’ve held that fund for close to a decade now. It has cut the payout a few times, but only because bond rates went down. Individually, junk bonds are risky. A group of two hundred of them aren’t. The risk is in interest rates, not so much with companies not paying.
If you’re interested in the whole leveraged bond market, there are dozens of such closed-end funds out there. I should really do a blog post on some of them.
Should you do it?
Yes, you should add junk bonds to your portfolio. They’re volatile, but they are also a pretty outstanding income source.
In the decade I’ve owned the asset class, I’ve basically broke even on the price of my fund and collected a dividend of approximately 10%. I’d call that a decent result.
There are just a couple of things to remember. First, consider them equities rather than bonds. They won’t be an ocean of tranquility when markets are falling. And don’t freak out about price movements. I’ve always considered the asset class a cash flow game. It’s the perfect investment to tuck away and forget about for a while, especially if you own it in a fund.