How To Make Money In Junk Bonds Review

by: Safety In Value

Robert Levine wrote "How to Make Money in Junk Bonds" as an introduction to junk bonds and to provide a method for selecting junk bonds in which to invest. The book provides an introduction to credit analysis, which is drastically different than equity analysis, because the upside is capped. This is done both with parable type stories and also with direct explanations.

The author calls his plan the "Strong Horse Method." Briefly, it's the idea that companies have both business and financial risk, and that the bonds of companies with financial risk due to high leverage but strong businesses can be an excellent investments. This is due to the higher yield offered.

The book covers the potential downsides to investing in junk bonds. Primarily, the downside is defaults. If the economy goes south as it did in 2008 an issuer may not be able to pay back its debt. Bondholders typically do better in bankruptcy than stockholders, but losses are losses. Additionally, the upside rewards to debt holders are limited, as the shareholders ultimately own the business.

The author does discuss the opportunities for capital gains in junk bonds, which come in a few different varieties.

Credit Upgrades/Investment Grade

This is a big potential benefit, since bonds are priced based on their credit rating. The biggest upside is when a non-investment grade security is upgraded to investment grade. This typically happens when the company's financial profile improves, either by paying down debt or improving earnings so the company's EV/EBITDA is more favourable. An excellent example of this is the recent upgrade of General Motors (NYSE:GM) to investment grade. As an investment grade company, GM is considered more likely to repay its debt, so the market accepts a lower interest rate for lending it money. This improves the price of the company's bonds, which equates to a capital gain for the company's bondholders.

Corporate Actions

The book also discusses corporate actions that can benefit bond holders. These range from early call of bonds at par (when they were purchased at a discount) to a merger or acquisition of the company by a corporation with a better credit rating or financial situation. An equity raise by a company can also improve the price of the bonds. This is because the bond holders have a claim on the assets of the corporation before stock owners, and the cash from the sale of the stock adds to the company's assets without a commensurate increase in liabilities.

The book also has an excellent glossary, from "basis point" to "yield to worst." It's probably worth the price of the book just for the glossary for someone new to junk bond investing. The author also has a chapter on picking a high yield bond fund for those without the money for a diversified bond portfolio or the interest in creating one. The author makes a compelling case for investment in lower rated securities, and the book is worth a read.

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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.