Junk Bond Millionaire

| About: SPDR Bloomberg (JNK)
This article is now exclusive for PRO subscribers.

Many investors have built up considerable retirement savings through dividend stocks and regular reinvestment - through either Dividend Reinvestment Programs - DRIPs - or periodic additional purchases. The basic concept of dividend reinvesting is to create a compounding effect - earning dividends from stock purchased with dividends. However, this concept can be applied to any security that makes periodic payments and is implicitly present in basic savings accounts at banks.

Considering high yield corporate bonds

One potential area for consideration would be junk bonds. Junk bonds, more euphemistically referred to as high yield corporate bonds, came into prominence in the 1970s and 1980s. Their higher yields reflect their lower credit quality which can be driven by the issuer's weaker finances, a lack of asset backing, subordination in the capital structure, or other reasons. A high yield bond will be senior to the issuer's equity, which provides some incremental safety relative to equity, but often junior to more senior and secured debt. On average, junk bonds should be less volatile and have lower correlations to the stock market than equities. However, junk bonds should have higher correlation to the market than investment grade corporate bonds and U.S. Treasury bonds.

I had previously written about the Procter & Gamble Company (NYSE:PG) in which I showed that over 40+ year span, a $35,000 investment (not counting reinvested dividends or taxes paid which would have additional impact) would transform into a position worth over a million dollars. While PG had a very good run for 40 years, picking a single stock can be a risky approach as the last few years have shown with "good, stable" banking stocks. High yield corporate bonds offer a lower risk of loss from bankruptcy than equities. I'm also looking at ETFs and mutual funds to capture a portfolio effect benefit.

Outperforming the S&P 500

I took a look at the SPDR Barclays Capital High Yield Bond (NYSEARCA:JNK) for the specific calculations. Unfortunately JNK has a pretty limited history. The basic assumptions are than an investor purchases 10 shares in the beginning of 2008 for $46.69 per share. Monthly interest payments are subsequently reinvested as well as another $100 each month. Over the four year span, these investments grow to 169 shares valued at almost $7,000. The following chart provides the detail on the how the position is formed:

Source: Developed from data from Yahoo!Finance

The first observation is that the bulk of the position is from additional shares purchased. Furthermore, the initial position actually lost value of $71 as the price fell from $46.69 to the recent closing price of $39.58, but in fairness this timeline spanned from just before the financial crisis to now. In comparison, the SPDR S&P 500 Trust ETF (NYSEARCA:SPY) closed at 139.58 on February 1, 2008 and is now trading at $131.82. Accounting for dividends and interest payments, JNK delivered a 29.9% return to SPY's paltry 2.6%. However, this is over a very, hopefully, unique period in investing history.

The second observation is that the bulk of the position is from the incremental investments. This is due to the short time horizon. As this process stretches out, larger portions of the final position will come from interest being reinvested.

These calculations also exclude taxes. Interest is taxed at marginal income rates not the preferred qualified dividend rate. Using an assumption of 28%, total taxes paid on interest would be $362. While the initial investment lost money, subsequent reinvestments appreciated. This would create an overall net gain creating an additional tax liability. However, by placing this in a tax advantaged account (e.g., Roth IRA), one could potentially eliminate or at least delay the tax liability.

Becoming a millionaire

So how does one actually become a millionaire with this approach? Unfortunately, there have not been any ETFs or mutual funds with sufficient time frames to account for reasonable investment assumptions (e.g., initial investment and recurring investment). In addition to JNK, other options include iShares iBoxx $ High Yield Corporate Bonds (NYSEARCA:HYG) and PowerShares High Yield Corporate Bond Portfolio (NYSEARCA:PHB). In this case, I created a theoretical example. Over the past four years JNK has provided an average yield of 11.1%. Assuming this rate, an average price at the recent closing price as the long run average (assumes no appreciation or depreciation), and a monthly additional investment of $100, it would take about 41 years to accumulate a million dollar position. this position would yield over $100,000 of income per year. The clear reason to do this in a tax advantaged account is that all that interest results in a $274k tax bill (assuming a 28% rate) over the 41 years. The initial investment is just under $400 with subsequent contributions totaling another $49,200.

However, this strategy is not without its risks and issues.

  1. In terms of retirement savings, a dollar today is worth substantially more than it will be in 41 years due to inflation. Assuming annual inflation of 2.5%, it will take $2.75 to equal $1.00 today. Should the target be higher?
  2. In the absence of a tax advantaged account, this would be a more challenging situation since the total return arrives in current income which is taxed that year. If you read my article on PG, a portion of the value was from capital appreciation which delays the taxes owed since the income (capital gain) would not be realized until liquidation. One approach would be to find a way to reinvest only a portion of the annual income, saving the rest for the tax bill.
  3. The assumed return of 11.1% is actually quite high. PG provided a return over 12% which is also anomalous. A lower return would require high initial savings (note the initial amount was just $400) or higher periodic investments. The following table summarizes the trailing yields on the three ETFs mentioned: Junk Bond ETF Yields
    Ticker Recent Close TTM Interest Implied Yield
    JNK 39.58 3.23 8.2%
    HYG 90.80 6.72 7.4%
    PHB 18.59 1.07 5.8%
  4. With respect to the real example, we've been in a long term period of declining interest rates which should have pushed bond prices higher. With the 10 year treasury under 2%, I have trouble believing that interest rates will not creep higher over the next 40 years.

How can you combat these issues? The simple answer is to invest more, earlier, and more frequently. For example, a starting position of $1000 instead of $400 would take 9 months off the time frame to get to $1 million. Incremental investments of $200 instead of $100 would reduce it 75 months. When it comes to saving for retirement, time and consistency are your best friends.

Disclosure: I am long SPY.

Disclaimer: This article is for informational and educational purposes only and shall not be construed to constitute investment or tax advice. Nothing contained herein shall constitute a solicitation, recommendation or endorsement to buy or sell any security.