Hot “Bonds” for Your Portfolio

by Dennis Miller | April 16, 2013 11:15 am

This week we’re picking up on research from my trusted colleague, Vedran Vuk. He’s been the brains behind the picks at Money Forever and wanted to share with readers some ideas on investing in bonds; especially important information for investors looking for yield.

There are two bonds worth talking about today: a basic bond, and a special derivative bond. The basic bond works as you might suspect; it pays a fixed, 2% yield, and in less than ten years, the bond matures. At that time, you will get back your principal, unless there’s a default. Since this is an investment-grade bond, the chances of default are low. Even if the market gets pretty tumultuous, you’ll receive your entire principal back. Furthermore, should the bond default, you’ll always get some money back as a creditor in the bankruptcy proceedings.

The really hot bonds on the market are derivative bonds. They pay a 3% yield, which blows the other bonds out of the water. However, if the company starts doing poorly, the bond issuer has the option to pay a lower coupon payment, but there’s an upside: If things are going well, the coupon payments may actually rise.

The yield isn’t the only thing that’s variable, though – the principal is as well. With a derivative bond, your principal isn’t guaranteed. It depends on how the market and the company are doing when it’s time to exit the bond. If market conditions are tough, the bond may repay only 60% or 70% of the principal – or even less. On top of that, these bonds aren’t considered senior secured debt. In the event of a bankruptcy, you would get nothing.

Many pundits out there are raving about the superiority of derivative bonds. Paying 3% while basic bonds pay only 2% is a big difference in a low-yield world. But what many investors don’t consider is the dangers of derivative bonds in comparison to basic bonds:

Sure, your coupon payments and principal may rise, but they also may not. When examining these risks, it’s easy to see that derivative bonds are a lot riskier than basic bonds. From that perspective, 3% yield does not seem to properly compensate one for the possibility of lost principal and coupon payments. Would you accept all of these risks for that single percentage point? If I were looking for yield alone, I wouldn’t.

Dear reader, I now must make a confession: There are no bonds like the derivative bonds described above. I made them up.

What I’m describing is a dividend-paying stock. Your dividends may rise, but they could be cut. Your initial investment may grow, or it could crash with the market. In the event of a bankruptcy, the bondholders will be secured, and you’ll get nothing.

I have misled you to demonstrate a point. Many pundits are saying that it’s pointless to buy a bond at 2% when you get yields on dividend-paying stocks yielding 3%. Their suggestions are a bit disingenuous, because bonds and equities are distinctly different asset classes.

If this were an apples-to-apples comparison, 3% definitely is better than 2%. However, instead we’re comparing apples to oranges – they’re both round fruits, but the similarities don’t go much further. Same goes with bonds and equities – they both pay yields, but their risks are very different.

Earlier when we pretended that both were bonds, you could easily see that equities or “derivative bonds” were a lot more risky than a basic bond. Income investing isn’t simply about comparing yields – the main issue is evaluating risk and yield together.

Furthermore, the way dividend-yielding stocks are often advertised ignores the most likely comparisons in the bond world. A U.S. Treasury paying 2% is not a good benchmark for a 3% dividend-yielding stock. The risks are nothing alike. If we were to make a comparison with a bond, it should be to bonds with market risk. Yes, such a comparison does exist; they’re called junk bonds.

If the stock market tanks, a portfolio of junk bonds will go down with it. Essentially, junk bonds have market risk very similar to equities. So here’s a novel idea: Since junk bonds and equities have similar risks, why not compare their yields instead of making a comparison to Treasuries? The junk bond fund Barclay’s Capital High Yield ETF (NYSE:JNK[1]) currently pays almost a 7% yield. That crushes the 3% on the dividend-yielding stock – meaning that the yield on the stock is actually not compensating you for the risk.

This doesn’t mean that yield-seekers should stay clear of stocks. What I’m suggesting is that you don’t compare bonds and equities on yield alone. By only comparing returns, you’re going to get creamed in the market. Your primary reason for owning a stock should be because it’s a good company. If it happens to have a good yield also, that’s a great secondary consideration.

If you’re hungry for yield, you need to consider every option out there – dividend-paying stocks, foreign currencies, municipal bonds, annuities… all these and more are worth a look.

  1. JNK:

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