Junk Up Your Portfolio (But Just A Little)

by: John Gerard Lewis

Forbes magazine columnist Richard Lehmann recently asserted that BB-rated bonds are not, as a whole, "junk." In fact, he contends "that BB-rated securities offer the best risk-reward combination."

That's welcome optimism for the income-starved, but it's also a bold statement in today's world. Yes, there are a few green sprouts - housing and jobless metrics have been looking a little better - but the economy is unanimously deemed shaky.

Still, investors are desperate for yield, and so they're taking risks that they haven't in the past. They're going way out on the maturity timeline and dipping their toes in the sub-investment-grade waters. Take a minute to digest this stat: In the third quarter, sales of junk bonds were nearly four times what they were in the same quarter a year ago.

Conventional wisdom would inform us that this "yield panic" is an example of en masse recklessness. And it may well be, but not necessarily because more money is flowing into junk. Rather, it's reckless because it is likely that many of these investors are misallocating the amount that they invest in junk.

Americans are conditioned to much higher yields on their investments than are available today. It wasn't so long ago that a standard bank savings account yielded 5-1/4%, and it was, as it is now, considered among the safest - and for many among the least attractive - of all investments. But today who wouldn't kill for a government-insured, demand-deposit account that yields 5-1/4%?

Unfortunately, investment-grade securities that return what investors are accustomed to receiving are scarce. But they want it anyway. They always had it before, they were counting on it in retirement, and now they're desperate to get it, even if they have to take more risk.

Okay, but can this somehow be construed as a rational approach? No, it cannot without due consideration for personal risk tolerance. The amount of acceptable risk for an individual depends on all kinds of variables - total assets, age, life style, etc. A quick, very generalized, illustration: A 30-year-old could go "all in" to BB-rated bonds for the same reason that he could invest all of his money in stocks. He has time to recover from any significant declines. An 80-year-old, on the other hand, might prudently devote just 10% or less to BB-rated bonds.

Thus, Mr. Lehmann's assertion about BB-rated bonds may be correct, but it needs some context, lest his readers dump all of their money into bonds that are less than investment grade.

In investing it all comes back to asset allocation, and whether BB bonds are junk is more matter of nomenclature than investment strategy. But unless there is a particular reason to avoid risk at all costs, there probably is a place in any given portfolio to reach rather far for greater yield. The overriding caution is that, notwithstanding Mr. Lehmann's risk/reward judgment, non-investment-grade bonds should comprise only an appropriate portion of a person's portfolio.

Once that percentage is determined, how does an individual go about making the investment? Two easy ways are through a mutual fund or by subscribing to a "mirroring" model.

The average credit quality of the DoubleLine Total Return Bond Fund (DLTNX), for example, is BB, and the fund yields about 6%. Manager Jeffrey Gundlach arrives at the BB average by taking a barbell approach, with 70% rated AAA and more than 20% rated B or below. The fund also has a particularly attractive risk feature: an average duration of 1.59 years, which roughly means that a 1% rise in interest rates would result in just a 1.59% decrease in net asset value.

Investment-mirroring websites may also contain models that seek higher yield without intending to take too much risk. One such example is my own Stable High Yield model at Covestor.com. Since inception (July 7, 2011), the annualized total return has been 8.2% (as of Dec. 12, 2012). I, too, take something akin to a barbell approach, with 42% committed to high-yielding mortgage real estate investment trusts and 43% in short-term bonds and cash. Covestor ranks the model's risk as "2" on a scale of 1 to 5, with "1" being the least risky.

"Investment grade" is an imprecise term, especially given the rating agency debacle of a couple of years ago. But allowing that it still describes securities of acceptable quality, it doesn't in turn proscribe a riskier, high-yield component in a portfolio.

Just don't go "all in."

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article. I am long DLTNX. I am also long the Covestor Stable High Yield model, of which I am the manager.