3 Tips for Digging Up Safe Junk Bonds

by Richard Band | January 9, 2013 9:15 am

The Wall Street Journal recently reported[1] that the average junk bond yield has plummeted below 6% for the first time ever. And that’s just the average — much lower junk yields are out there.  Some of the “classier” junk (rated BB by Standard & Poor’s) is now quoted with a four handle.

It’s the dilemma of a lifetime for income investors. Thanks to the Federal Reserve’s ongoing zero interest rate policy on short-term money, yields have fallen drastically on all types of paper — government, corporate, bank and municipal — and on all maturities, even the longest.

So, what’s an income investor to do?

Screening for Safety

If you need investment income to live on (because you’re retired, say), you can get some of it by substituting stocks for bonds. BP (NYSE:BP[2]), one of the largest oil stocks in the world, yields over 5%. Or you can earn 6% to 8% by stepping up to master limited partnerships[3].

Let’s face it, though. Equity always poses a certain risk that bonds don’t. In a pinch, a company can cut its dividend with no adverse business consequences. Management generally can’t stop paying bond interest without filing bankruptcy.

So, bonds deserve a place in your portfolio[4], even at today’s low interest rates. But what kind of bonds? Here are three guidelines:

Avoid most investment-grade bonds. The yields on highly rated bonds, after taxes and inflation, are just too meager. (Of course, if you bought IG bonds years ago, at higher yields, you should keep them.) Instead, I recommend that you carefully and judiciously accumulate bonds in the high-yield category, often contemptuously dismissed as “junk.”

Some junk bonds deserve the name. But there are ways you can screen out the shoddy merchandise and keep the genuine bargains.

Avoid outrageously high yields. When it looks too good to be true, it generally is. Junk bonds with yields of 9% and up yields imply an unacceptable risk of default.

Click to Enlarge
Emphasize bonds with short maturities.
Research going back over the past two decades has shown that high-yield bonds with a short term to maturity return almost as much as longer-dated bonds, with substantially smaller price fluctuations. One recent study, focusing on the period from 2006 to the present, is depicted in the graph.

As you can see, short-term junk bonds (with a maturity of one to five years) delivered 91% of the return from the high-yield market as a whole, with only 75% of the volatility. So, on a risk-adjusted basis, the short-term bonds outperformed the high-yield universe by a margin of about 1.2 to 1.

An Easy Way to Get Started

For investors who hesitate to buy a pure junk bond fund, I advise taking a baby step. DoubleLine Total Return Bond Fund (MUTF:DLTNX[5]) invests in mortgages. Three-quarters of the fund’s holdings are rated investment grade, and 65% are AAA quality. Only about one-fourth could be considered “junky.”

As a further precaution, portfolio manager Jeffrey Gundlach keeps maturities short. The fund’s duration — which measures how long it would take, on average, for the fund to get all its money back (principal and interest) — is around two years.

Yet, in spite of the fund’s short-term orientation, DLTNX yields 5.3%, based on the most recent three months’ distributions. That’s a superb payoff for a fund that doesn’t tie up your money in long-term paper.

Remember, too, that the Federal Reserve is supporting your investment by purchasing $40 billion a month of mortgage-backed securities. Until that policy changes, it’s hard to imagine a fund like DoubleLine running into serious headwinds.

Richard Band’s Profitable Investing advisory service helps retirement savers outperform the market without losing a minute of sleep along the way. His straightforward style and low-risk “value” approach has won seven “Best Financial Advisory” awards from the Newsletter and Electronic Publishers Foundation.

  1. The Wall Street Journal recently reported: http://blogs.wsj.com/marketbeat/2013/01/04/junk-bond-yields-break-through-6-barrier/
  2. BP: http://studio-5.financialcontent.com/investplace/quote?Symbol=BP
  3. by stepping up to master limited partnerships: https://investorplace.com/2012/12/mlps-the-place-to-be-in-2013/
  4. bonds deserve a place in your portfolio: https://investorplace.com/2013/01/bonds-for-retirement-ibm-ko-msft-xom-pg-jnj/
  5. DLTNX: http://studio-5.financialcontent.com/investplace/quote?Symbol=DLTNX

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