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Are Junk Bonds for You?

As we have seen in earlier posts, a bond is a loan made to a government or corporation with the borrower obligated to pay back the principal with interest at maturity. The creditworthiness of the borrower (bond issuer) is reflected in the bond’s credit rating; the better the ability of the issuer to meet their debt obligation, the higher the credit quality of the bond.

Bonds with superior long-term credit ratings (AAA, AA+, AA, etc.) are known as prime or high-grade bonds. These bonds are issued by companies with a solid track record and the high rating is a testament to the issuer’s ability.

On the contrary, there are some corporations that have a poor record of meeting their debt payments (whether late or default) or do not have a long history but still need money to finance their activities. Since investors would be unwilling to part with their cash for such a corporation’s bond, the company will have to lure investors through their high bond interest rates. Due to the speculative nature of such bonds, they are called  junk bonds or, to put a positive spin, high-yield bonds. Usually, the credit rating of such junk bonds are BB, B+, B-, CCC, etc. to reflect the potential risk of default.

Junk bonds in the current interest rate environment

Until a few years ago, the Canadian junk bond market was virtually non-existent after it went into a dormant state in 1990 and companies sought refuge in the established US junk bond market. However, due to the current low interest rate environment, a few companies have started borrowing in Canada by issuing junk bonds; a short list of junk bond issuers is available here (second page of above link). A point of note for junk bonds is the yield spread; in other words, the difference in yield between a junk bond and government debt. The yield spread is important as it helps in identifying whether the reward (higher yield) outweighs the risk (default).

Junk bond ETFs

As with other asset classes, junk bonds are also available as ETFs to help mitigate the impact of default that gains focus when buying a few individual junk bonds. iShares iBoxx High Yield Corporate Bond Fund (ticker: HYG), SPDR Barclays Capital High Yield Bond Fund (ticker: JNK), and PowerShares Fundamental High Yield Corporate Bond Fund (ticker: PHB) are some of the options available to investors interested in going this route.

A short list of high-yield junk bond ETFs is available at ETFdb. As the stock markets alternate between fear and confidence, the market rallies have fueled the performance of such junk bond ETFs. Nonetheless, the pickings seem slim in the Canadian junk bond category with the AGF Canadian High Yield Bond Fund being the prominent player.

Similar to other bond ETFs, it would be useful to look at the liquidity, expense ratio, default rate, yield spread, fund composition, and direction of the fund (strategic changes) when looking to invest in junk bond ETFs.

Are junk bonds for the average investor?

As should be evident from above, the risk with junk bonds is that the investor may never get their principal back due to the poor creditworthiness of such bond issuers. In addition, if looking for individual junk bonds, the investor should be fairly knowledgeable about credit quality. Typically, institutional investors have the resources to conduct elaborate research to filter the better ones. Although an average retail investor may get the chance to diversify across different asset classes by buying some of these high-yield junk bond ETFs, the risk may not be worth their while.

Do you invest in junk bonds? Individual or ETF? How have your investments fared? Do you have any tips to offer for interested investors?

About the Author: Clark works in Saskatchewan and has been working to build his (DIY) investment portfolio, structured for an early retirement. He loves reading (and using the lessons learned) about personal finance, technology and minimalism.  You can read his other articles here.

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About the author: Clark works in Saskatchewan and has been working to build his (DIY) investment portfolio, structured for an early retirement. He loves reading (and using the lessons learned) about personal finance, technology and minimalism. You can read his other articles here.

{ 10 comments… add one }
  • Amit Bhatnagar February 1, 2012, 2:27 pm

    I keep 2% of my overall portfolio in HYG and 2% in JNK. Both of these give me 7-8% dividends in good times or bad, and were no worse than S&P was in 2008 downturn. At this moment in the last 4 years they are both around 4% up from when I bought them but their dividends have boosted their return to 17% for HYG and 27% for JNK, so I am quite happy with them.

  • Mun February 1, 2012, 3:40 pm

    Thanks for the non-jargony explanatino about junk bonds. I will be graduating from college soon and I’m starting to think about my investment options. This post helped a lot :)

  • Howard Hare February 1, 2012, 6:04 pm

    I have about 10% allocated to a Portfolio that is designed to generate cash flow, I do not care about the NAVPS, I am holding these as if they were an apartment building, I just want the rent cheques, my Estate can have the assets when my will is settled.

  • Joe February 2, 2012, 1:14 am

    In the long run, ‘owners’ make more than ‘loaners’. Because of the risk/return relationship, junk bonds will return more than regular bonds. Creditors are, however, still hire on the totem pole than investors. The long run returns of such lenders will never, overall, exceed the returns of owners of such companies. Otherwise the capital-allocation system would fail, as nobody would want the diminished standing of an owner during the orderly procession of the settlements of debts. Just a thought; but if you’re at a stage where you want a larger portion of fixed income and can’t stomach the dismal below-inflation rates on AAA bonds, then such ETFs seem like a wise vehicle for some of your holdings. Everything in moderation.

  • Be'en February 2, 2012, 4:44 am

    Is iShares Hybrid bond etf (XHB) any good? Why is it called “hybrid” instead of high yield? Holds mostly BBB rated bonds.

  • Chuck February 2, 2012, 12:04 pm

    I just cashed in my bonds and 401k. My wife and I purchased a small cabin in the woods where the air is fresh and there is no people. Save for your future folks so you can blog in your underwear when you are old:-)

  • Fit February 2, 2012, 1:26 pm

    junk bonds are a funny animal haha back in the 80’s junk bonds weren’t actually junk lol but now… who knows…. With the compression in the debt market, there are some real gems mixed in with the stinkers haha

  • Saveddijon February 3, 2012, 10:19 pm

    Somewhat related: does anyone have opinions on MHY.UN?

    In theory, higher yield, but not junk. What has been your experience?

  • Al February 4, 2012, 3:09 pm

    I agree with Joe, owning is better than loaning. But Mr Market doesn’t always price risk and return appropriately. In early 2009 you could buy distressed bonds for pennies on the dollar giving you effectively equity upside with bond risk. With enough homework there were some gems to be had (and as Fit suggests, there are probably some around today). Most high yield bond funds returned better than equities that year and many individual high yield bonds returned even more (this is globally, the Canadian dollar high yield market is a tiny tiny market).

    Personally I have bought individual HY bonds twice, luckily in both cases things worked out.

  • Falo February 7, 2012, 7:15 pm

    Thanks for this post. Great info. I am interested in these etfs as I really like the cashflow, however I am wondering if you know how they will be treated from a tax prespective. I checked out HYG and JNK and both contain mostly US bonds, so would this mean that their dividends are taxable at 100%. I’d appreciate a bit of a high level summary of the major etfs along with their tax impact and best strategy (eg. should be kept in a TFSA vs. RSP vs. unregistered)

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