Beat Stock Returns 3-to-1 — If You Act Now
Stocks have been on a tear the past few months — no doubt about that.
Investors who bought in at the market’s March 6 ebb have seen a +52.8% return in the the S&P 500. Even investors who entered the market at the beginning of the year have seen a +14.4% gain.
That’s a nice gain, but the investors who earned it missed out on a far better return, plus the opportunity to lock in a high yield.
True story: The typically shunned securities I’ve found have walloped stocks this year — returning +38.6% on average from the start of the year through mid-August — and their yields peaked at a record 21.8% just a few months ago.
These assets are safer than any stock in at least one key way. If you own this asset and the issuing company goes into bankruptcy or liquidation, you’re higher on the pecking order than any common or preferred shareholders, who may get nothing.
Despite their strong rise this year, despite their relative safety to stocks and despite their sky-high yields, most investors still avoid this asset class.
It’s a branding problem. Too many people are tripped up by the name “junk bonds.” But you shouldn’t be scared away, especially if you’re looking for double-digit yields in today’s market.
The Most Lucrative Time to Invest
“Junk” bonds are any bonds rated “BB+” and lower by Standard & Poor’s or “Ba1” and lower by Moody’s. These bonds generally rise and fall with the fortunes of the economy, since that’s the biggest factor as to whether the parent company can cover the bond obligation. (Most non-junk bonds are more sensitive to interest rates than the overall economy.)
Investors tend to dump junk bonds during economic downturns because they’re less likely to be paid back. The result is depressed prices and high yields. The bonds tend to rise as the economy recovers and the risk of default lessens.
So the period after an economic downturn and before the recovery is usually the sweet spot to lock in the most lucrative junk-bond yields. We seem to be at that point right now.
The credit crisis pushed default rates on U.S. junk bonds to a six-year high of 11.5% in July, Moody’s said, up from 2.7% in July 2008. The rating agency predicts that U.S. speculative-grade default rates will peak in the fourth quarter this year at 12.7%.
The rapid rise in defaults led investors to dump the bonds with abandon. Junk bonds bottomed in mid-December. As prices plummeted, yields rose to a record 21.8%.
But most of the fears about the severity of the Great Recession have abated, and yields have dipped as prices have risen. Between October 2008 and April 2009, yields held stubbornly above 15% according to the Merrill Lynch High-Yield Master II Index. They’re moving lower again, but the sector still yields an average of 11.4% as of late August.
Despite the improvement in the outlook for junk bonds, they still have room to run. The yield spread between junk bonds and Treasuries is still historically high. For the past few years, investors were satisfied with spreads of between 2% and 4%. As of two weeks ago that spread was about 9%. With junk bonds prices at 80% of par value instead of their historic 90%, prices still have room to rise.
There’s always the risk the United States could slide deeper into recession, which would hurt the bonds. That’s unlikely. Most agree the worst has passed. Many pundits, including Alan Greenspan and Ben Bernanke, share this outlook, although the potential for a strong recovery isn’t clear. This lack of clarity is a good thing, though. It’s why the opportunity in junk bonds still exists, even though Moody’s expects default rates in the U.S. to retreat to 3.8% by this time next year.
If you can avoid being put off by the name, junk bonds offer one of the most attractive opportunities around for income investors.
One thing to note: With junk bonds, diversification across companies and industries is crucial, and it’s best achieved with exchanged-traded funds or mutual funds. They may not throw off yields as high as some individual bonds, but being able to purchase a stake in dozens of bonds at once is a necessity, especially until there’s a clearer sense of a strong economic rebound.