Why High-Yield Bonds Might Be a Better Trade Than Stocks

11/23/2010 12:01 am EST

Focus: STRATEGIES

John Jagerson

Co-Founder and Contributor, LearningMarkets.com

High yield bonds, or "junk bonds," present interesting possibilities for investors. I would propose that right now, while the economy is settling and the actual length of time the recovery will take is uncertain, high-yield bonds could be a very attractive investment.

Bonds are debt. A company with capital needs will issue bonds that are then purchased by investors. The bonds pay interest to the buyers (or lenders) that will vary based on the quality of the issuer (or borrower).

Generally speaking, corporate bonds fall into three categories:

The first category is "investment grade," and such bonds are usually A-rated by credit rating agencies like Standard & Poors or Moodys. Investment grade bonds commonly pay 3-5% more than the yield available on the ten-year Treasury note.

High-yield bonds are rated below investment grade as B- grade or worse. A high-yield bond is considered to carry a higher risk of default or non-payment, and therefore, the interest rate must be much higher than an investment grade bond. It is common for junk bonds to pay 7-10% more than the yield available on the ten-year Treasury note.

Bonds that are rated below junk (C - D) are considered "distressed" and highly speculative. Usually individual investors steer clear of these kinds of investments. A distressed bond will pay 10% or more than the yield available on the ten-year Treasury note.

While high-yield bonds are considered high risk, the larger return potential makes a diversified pool of them attractive as a component of a diversified portfolio. While it may be possible to buy these bonds through your broker, you may be surprised at how much it costs to do so. For smaller investors, buying individual bonds probably doesn't make sense. Fortunately, there are great alternatives.

In the video below, we will talk about how to buy a high-yield bond portfolio through ETFs or funds. This way you can trade them like stock, pay much lower costs, and start with a diversified pool of bonds right from your first purchase.

Bonds are interesting right now because growth is so uncertain. Growth is required for a stock to increase in value, whereas a company can make interest payments without growing. If you are pessimistic about the economic recovery and think it will take a while for companies to start growing again, high-yield debt may be a good alternative.

Keep in mind that bonds carry specific risks. Like stocks, a bond may lose value when the markets drop. They are sensitive to rising interest rates and accelerating inflation. However, over the last ten years, while the major stock indexes have returned nothing, several high-yield bond funds and ETFs have been returning 3-5% per year, on average. For a prepared investor, these funds may present an ideal addition to a diversified portfolio.

To see a video on the subject, visit LearningMarkets.com.

By John Jagerson of LearningMarkets.com

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