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In my previous article entitled "The Issues with Corporate Junk Bonds", I determined corporate junk bonds do appear to be currently offering a somewhat higher future return than corporate investment-grade bonds with a similar years-to-maturity. This appears to be so whether we are talking about the junk bond ETFs iShares iBoxx $ High-Yield Corporate Bond (NYSEARCA:HYG) and SPDR Barclays Capital High-Yield Bond (NYSEARCA:JNK) or the kind of individual bonds HYG and JNK hold. There are additional issues to consider in deciding whether to buy and/or hold HYG or JNK or individual corporate junk bonds though.

Junk Bonds Are Meant to Be Purchased By More Knowledgeable, Involved, and Speculative Investors

Another issue with junk bonds is they are meant to be purchased by more knowledgeable, involved, and speculative investors. The number of bond defaults varies a lot over time. It is better if you are good at projecting default rates if you invest in junk bonds. With corporate junk bonds, you can swing from almost no default losses to 20% or more default losses in a year. 2002's 11.51% default losses were not nearly the worst scenario that can occur, and corporate junk bonds are becoming junkier. If you buy or own individual junk bonds, it can also be important to be good at evaluating a company's ability to pay you back.

Yes. Sure. You can simply invest in a junk bond fund and/or a more heavily traded, well diversified set of junk bonds with the intention of riding through the bad times in the knowledge that, in the long run, junk bonds should do a little bit better than regular bonds. For one, though, if you have an individual junk bonds portfolio, you will need to purchase, hold, and monitor many different bonds to be properly diversified―maybe twice the number of bonds you need to purchase, hold, and monitor for proper non-investment-grade diversification. Also, if you do not genuinely understand, in advance, how bad things can get, if/when they do get this bad, you may end up selling at a deeply depressed price(s). From their introductions in 2007, the price of HYG fell over 40% by 3/9/09; and the price of JNK fell over 45% by the same date. This is not the worst it can become.

Corporate Junk Bond Prices Tend to Move in Conjunction with Stock Prices

Another issue with corporate junk bonds is their prices tend to move in the same direction as stock prices. This negates one of the reasons for holding some bonds in your investment portfolio. This reason is bonds prices tend to move in the opposite direction of stock prices or be much steadier than stock prices. In the chart below, the yellow line is HYG, the blue line is JNK, the red line is Vanguard Total (U.S.) Stock Market ETF (NYSEARCA:VTI), and the blue-green line is iShares iBoxx $ Investment-Grade Corporate Bond ETF (NYSEARCA:LQD).

(click to enlarge)Junk Bond Prices Chart - 121031

In looking at the chart, you can see the prices of HYG and JNK have a much stronger tendency to move in concert with the price of VTI than the price of LQD does. This is despite the fact LQD's average years-to-worst is about twice that of HYG and JNK. (A higher years-to-worst makes the price of a bond fund more volatile.)

Bonds, in General, Are Pricey Now

Another issue with junk bonds is bonds, in general, are currently pricey. Interest rates are unnaturally low. This condition is unlikely to persist in the intermediate/long-term. Using techniques I used in previous articles, I calculated that, if HYG and JNK have a YTW of 6 years (which is approximately correct), if/when interest rates return to the much more usual levels they were at before the last recession, HYG and JNK will experience a related principal loss of about 10.28%. Over the course of a 6 year investment, this is 1.71% a year. With the tax effect at a 15% capital gains tax rate accounted for, this is 1.46% a year. With these losses factored in, HYG and JNK appear to lose money over the course of a 6 year investment in the highest U.S. federal income tax bracket. In the other tax brackets, HYG and JNK appear to still make some money over the course of a six year investment (assuming there are no applicable state or local taxes), but not nearly enough to be better than investing in a well-chosen 5-year CD (which has a years-to-worst of about 1 year less).

For individual corporate junk bonds held 6 years to maturity, the junk bonds appear to outperform CDs in all tax brackets―unless you can get a special, very good interest rate on the CD. Also, individual corporate junk bonds appear to outperform individual investment-grade municipal bonds in all tax brackets because shorter-term investment-grade municipal bonds are not, currently, well-competitive investments―and these are investment-grade municipal bonds, versus junk municipal bonds which may compete better. (Intermediate/longer-term municipal bonds are well-competitive.) I derived these conclusions using data from my previous articles entitled "The Best Intermediate-Term Non-Junk Individual Bond Investments" and "The Best Short-Term Non-Junk Bond Investments Are CDs, Not Bond Funds or Bonds".

None of the above-mentioned fixed-income investments appear to be, currently, a better investment than stocks; but you may need or want some fixed-income investments in your portfolio. As I explained in my article "Your Retirement Investments: Stocks vs. Bonds", stocks prices tend to appreciate 8.88% per year―6.66% less inflation. Also, stock prices are currently relatively low.

Conclusion

What will happen in the short-term is difficult to predict; however, HYG and JNK appear to be poor intermediate/long-term investments. Yes, currently, HYG and JNK appear to be a little better than similar years-to-maturity investment-grade corporate bond ETFs; but, when interest rates rise, which they almost inevitably will, it appears as if HYG and JNK will suffer a good-sized related loss in principal. CDs are better investments. This is especially true since they are a lot less risky than corporate junk bonds.

On the other hand, individual corporate junk bonds appear to be good fixed-income investments. Investing in individual corporate junk bonds is not for everyone though. If you are going to invest or are invested in these, you should understand how default losses will likely impact, and can worst-case impact, your investments. You should be genuinely prepared in advance for the ride if the ride becomes very ugly. Ideally, you should be good at evaluating a company's ability to pay you back. Your junk bond holdings should be extra diversified. You may want to make some accommodation for the fact that junk bond prices move in conjunction with stock prices. You should be adept at buying individual bonds cost-effectively, and you should have and take the time to monitor each bond investment and each company that issued a bond you hold.

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.

Source: The Issues With Corporate Junk Bonds: Conclusion