Junk Bond Investing

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Junk Bonds: Why One Man’s “Junk” Is Another Man’s Treasure
by Alexander Green, Chairman, Investment U; Investment Director, The Oxford Club
Monday, November 5, 2007: Issue # 727

Despite two interest rate cuts from the Fed, concerns about the strength of the economy and the persistence of the credit crunch have so far kept high-yield bonds – or junk bonds – under pressure.

Look at the closed-end funds, in particular. The gap between the value of the bonds held by these funds – their net asset values – and their market price is at historic highs.

If you’re looking for an attractive dividend yield, plus capital appreciation potential, there are plenty of opportunities available in this sector.

Yet Wall Street appears virtually blind to what’s happening here. In fact, most firms’ asset allocation models don’t even include an allocation for high-yield bonds. I find that curious.

Why “Junk Bonds” Are Not Big On Wall Street

Here are the objections I generally hear:

1. Bonds should be in your portfolio for safety. (This may be true, but putting more volatile assets in your portfolio actually reduces the risk of the portfolio as a whole.)

2. High-yield bonds are extremely tax inefficient. Their interest payments are taxed at the rate of income, not the lower capital-gains tax rate. (This is true, too. But that makes them perfect for your IRA or other qualified retirement plans.)

3. High-yield bonds are more closely correlated to stocks than investment grade bonds. (True again, but so what? They don’t move in lock step with the stock market and there are plenty of times when high-yield bonds perform better than equities.)

To those that prefer low-yielding investment-grade bonds, I might add that, as junk bond king Michael Milken told us two decades ago, the rating on triple-A bonds only has one way to go.

Sure, sometimes these obligations maintain their standing. But in no case do triple-A-bonds receive upgrades.

How Investors Can Benefit from Investing in Junk Bonds

Right now investors should consider owning high-yield bonds for several reasons.

Historically, high-yield bonds have posted better returns than investment-grade bonds.

Secondly, high-yield bonds have a fairly low correlation with both Treasuries and triple-A corporates. They are good diversifiers.

Thirdly, blending high-yield bonds with other asset categories actually reduces your overall portfolio volatility while increasing your returns.

And, bear in mind, owning a fund that holds a broadly diversified portfolio of high-yield bonds is a lot less risky than owning one or two issues. (That’s particularly true, of course, when these funds are trading at double-digit discounts to their net asset values.)

In short, investing 5% to 10% of your portfolio in high-yield bonds is likely to give your whole portfolio a long-term performance boost. It’s one reason why The Oxford Club’s asset allocation model has beaten the S&P 500 by a wide margin over the past five years, while taking much less risk than being fully invested in stocks.

One Junk Bond For Consideration

There are a number of high-yield funds trading at mouth-watering discounts right now. Take, for example, the Western Asset Global Partners Income Fund (NYSE: GDF).

The fund has a great deal of flexibility, investing in high-yield and high-grade bonds both here and abroad. (A large portion of the portfolio is in Brady Bonds.)

The fund is currently trading at a whopping 15% discount to its net asset value. And it pays dividends monthly.

Global Partners is an excellent choice for investors looking to generate a high total return without increasing their exposure to stocks.

Good Investing,

Alex

Editor’s Note: Thirty-two of Alex’s 35 recommendations in the Oxford Trading Portfolio are in positive territory right now. The total return of this portfolio’s open positions is 103%. Get all of his picks – from growth stocks to high-income plays…

Today’s Investment U Crib Sheet

Yield-hunting investors gobbled up junk bonds through the first four weeks of October

According to Reuters, junk bond mutual funds reported a net inflow of more than $420 million. And AMG Data reported heavy bond buying last week, too.

“Excluding ETF activity,” taxable bond funds received net inflows of more than $1 billion.

The Western Asset Global High Income Fund, of course, still trades at a deep discount to its net asset value (NAV). Yet it’s posted a 10.45% annual return since its inception in 1991. And right now, its price-to-book ratio is less than 1.

To learn how closed-end funds work, and why they can be so profitable, read Closed End Funds: The Only Funds that Go On Sale from Investment U.