Shopping for junk doesn’t exactly have a luxurious ring to it, whether you’re hitting a salvage yard for a ’62 Ford Falcon horn or combing through VHS tapes of “Sweatin’ to the Oldies” at a rummage sale. So think about it: Why would anyone buy a product called a junk bond — conceived, after all, by that legendary felon Michael “the Junk Bond King” Milken?
As fine a question as that might sound, it overlooks the obvious. Wall Street, that funny little financial district where irrational exuberance is king, bases a good part of its existence on curious ways to wealth. So people not only invest in junk bonds, they can also buy exchange-traded funds that deal in them. The SPDR Barclays Capital High Yield Bond even has a cheeky stock exchange ticker to go with it: JNK.
Can any good come of sinking a chunk of change into junk bonds? No, according to some experts.
[See: 8 Bond ETFs to Cope With Rising Interest Rates.]
“Investors should run, not just walk, from junk bonds,” says Eric Nelson, CEO and managing principal at Servo Wealth Management in Oklahoma City. “They have no place in a portfolio.”
Nelson’s disdain stems from a phenomenon he’s observed where “junk bonds go up in bull markets — but not as much as stocks — and go down a lot in bear markets, unlike investment grade bonds. Heads you lose, tails you don’t win.”
Then again, maybe the main thing wrong with junk bonds is the name itself, as many investment pundits sing their praises.
“The word ‘junk’ should be changed to something that can better convey it’s just a risky asset,” says TradingView chief operating officer and co-founder Stan Bokov. “Cryptocurrency can be arguably more risky, yet it doesn’t carry the same stigma.”
“A good corporate salesperson should always refer to junk bonds as high-yield bonds,” says Angelo DeCandia, professor of Business at Touro College in New York City. “They usually sell at deeply discounted prices and hence deliver high yield, thus accentuating the positive.”
So how do junk bonds work? Three ratings agencies assign grades to bonds, with AAA or Aaa being the highest, also known as prime. When an investment falls below BBB- (Standard & Poors, Fitch) or Baa3 (Moody’s), it becomes junk as opposed to investment grade. Yet even within junk status, there are four risk tiers before a company hits partial or full default.
“High-yield bonds are a source of debt financing from public corporations that are assigned ‘below investment grade’ ratings from credit rating agencies,” says Loren Asmus III, vice president, investment research at Canterbury Consulting and based in Newport Beach, California. “Investors are assuming more credit risk but to achieve potentially higher returns.”
[See: The 9 Best Municipal Bond Funds for Tax-Free Income.]
That’s the tradeoff to consider before you sell that junk in your garage to finance a junk bond purchase. These bonds base their generous interest rates on the fact that companies in somewhat shaky condition issue them.
“An extreme downside example would be a newly issued high-yield bond that defaults before even a single coupon is paid,” says Karl Mayr, managing director at 280 Securities and based in Westport, Connecticut. “This occurred in 2015 on bonds issued by American Eagle Energy Corp., under the strain of slumping oil prices and overleverage.”
“High-yield investors should tread warily,” DeCandia says. “Warren Buffett has been known to derisively refer to the sector as ‘weeds priced as flowers.’ And there are times when his assessment has been correct.”
But on the whole, junk bonds defy their mopey moniker.
“In fact, only 5 to 10 percent of companies issuing junk bonds actually default and in turn have negative impact on their investors,” says Mark O’Brien, senior vice president of sales and marketing at Advantage Data, headquartered in Boston. “That means 90-95 percent of so-called junk bonds turn out just fine.”
What’s more, “When these bonds do default, they often have a ‘recovery value,’ meaning they are not necessarily worth zero,” says Fran Rodilosso, head of fixed-income ETF portfolio management at Van Eck Securities Corp. in New York City.
Rodilosso notes that some very respected public companies have used high-yield bonds, including Tesla (ticker: TSLA) and Netflix ( NFLX): “In the case of Netflix, the buying spree of original programming the company has undertaken in recent years has been mostly financed through the junk bond market.”
Observers also contend that other factors influence the junk bond market besides any rumblings on the company campus. “When the economy begins to perform poorly, the market for junk bonds will also be one of the first to do poorly as well,” says Scott Krase, founder and president of CrossPoint Wealth in the Chicago area.
One way to presage this, Krase explains, is by looking at the spread between U.S. Treasurys and CCC-rated high-yield bonds over the last 20 years. “When spreads widen by more than 4 percent or 400 basis points, it may indicate that a junk bond market that has already faced major declines will face further declines.”
So what about the present? While the economy is gangbusters for now, junk bonds aren’t the screaming bargain they could be.
[See: 7 Bond Funds to Buy as Rates Rise.]
“Junk bonds are a great investment at the right time but currently spreads to Treasurys are near historical lows,” says Mark Painter, president of EverGuide Financial Group in Berkeley Heights, New Jersey. “So investors are not getting compensated for the risk they’re taking. In other words, junk bonds are extremely expensive right now near the end of the cycle, so it makes sense to wait until they get cheaper.”
Imagine that: Junk that’s expensive, but worth the wait.
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How Investors Find Treasure in Junk Bonds originally appeared on usnews.com
