Why Junk Bonds Are No Longer Junky

Junk bonds live at the bottom of the barrel below investment grade, and many times they are debt instruments sold by companies that have a poor track record of paying debt back. Many other times, however, bonds are labeled as junk solely because the rating agency fears that the issuing company will not pay them back. However, these fears are not always in line with reality.

Junk is Oversold

Junk bonds, unlike other bonds, often trade very much like stocks. Investors view junk bonds and stocks virtually in the same manner; individually they're risky, and when diversified, they're rewarding.

There is one exchange-traded fund that is performing quite well with its junk bond endeavors: SPDR Barclays Hybrid ETF (JNK). At present, the fund yields tremendously at 13.6% and has fared well even as the market has dropped; the fund is only down 6% year to date.

Playing it Safe

There are a few strategies to tackling the benefits of junk bonds while avoiding the negative sides. With the SPDR Barclay's Hybrid ETF, investors could long the stock while protecting themselves with relatively inexpensive put options to cover the chance of a falling stock price. At a price of $1.50 for December $30 strike price puts, investors can protect themselves while enjoying the robust 13.6% dividend yield. Should the ETF tank, investors would be protected nearly dollar for dollar on the fall and make up any difference with the dividend. And if the ETF were to soar on better economic outlook, only a small price would be paid for insurance to the downside.

Diversification is the Key

For any instrument speculative in nature, diversification is an extremely important element to making money. Granted, some of the bonds held in the ETF may not be worth a dime a year from now. Others might be worth twice what they are now. Holding a variety of junk bonds, rather than just one or two, ensures investors that even if a few bonds fail to deliver, a variety of others will pick up the tab with their high yields. There couldn't be a better time to diversify into junk debt; treasuries yield virtually nothing and all other forms of fixed income barely beat inflation. Junk is the way to go.

Disclosure: I own no Junk Bonds or funds that track them.

Comments

[F. Bradeen:]

It's interesting that you like JNK but unwilling to buy them. Your plan won't work as there is no volume in the JNK options.

I do have a hedge on that I am watching to see how it works out. For every 1000 shares of JNK you buy, buy 100 Shares of BGZ, which is a tripple short on the market. I am a little nervous about this hedge position as there is only 6 months of history, but it is working so far in actuality of one month.

Possibly other hedge vehicles would be better, like put options on the SPY or something like that. Any comments from all are welcome.

May 20 04:10 PM

[user396040:]

I have done well with junk bonds lately - including AFC, GMAC bonds, the Financial Security Assurance bonds(FSB,FSE,FSF) and the Helios funds. The sector has moved up a lot lately but I think it is still undervalued. There may be short the stock/buy the bond hedge opportunities opening up. There is also HYG (high yield I shares) and a bunch of closed end funds, most of which are trading at discounts to NAV. You get paid a very good yield while you are waiting and, even in a bankruptcy, you are likely to get something(probably equity in a recaptialized entity). I think it is still a good strategy but spreads are starting to close up.

May 20 07:22 PM

[Hiyield007:]

JNK is not down 6% for the year. It's not up as much as other junk bond funds because it came into 2009 with a huge premium to its NAV and it worked that premium off early in January. Some of the open end junk bond funds, which track the cash market and trade at NAV, are up 18% to 20% and more YTD. So I wouldn't say the market is oversold as we are on track for the best year in junk bond history which was 1991.

May 21 02:32 AM

[Buy and Hol...:]

Since JNK pays out on a monthly basis, then maybe the way to play it is to buy it before the ex date and sell covered calls. If you're looking for income, that might do the trick. And if it gets called away, so be it. Book your profits and move on.

If it does go down in price, take the income and close out your position and move on.

May 21 09:31 AM