Don't Count On This New Favorite

Successful investing requires a balancing act between two important things: the desire to make as much money as you can from your investment versus the wish to preserve your capital in case things go wrong. With one increasingly popular investment, however, the limited reward that's available to investors today doesn't justify the potentially huge risks if the economy fails to maintain its upward track.

Reaping riches from junk
Late last year, the financial crisis sliced the bond market in two more sharply than a Ginsu can slice a tomato. On the one hand, Treasury bonds soared as panicky investors fled to the assets they considered the safest. On the other hand, with many companies completely unable to tap the credit markets at all, demand for some types of corporate bonds all but evaporated, and investors who owned them lost huge amounts of money.

But now, the tables have turned, and everyone is piling into all sorts of bonds, including junk. Treasury bonds have actually lost value this year, even including interest payments. Their rates are still so low that yield-starved investors are flocking to any alternative that offers higher income, regardless of the risk involved. The demand has helped corporate bonds produce huge results so far this year.

Understanding risk
And unfortunately, the market for corporate bonds does involve more risk than investors are giving credit for right now. For instance, high-yield "junk" bonds usually trade at a substantially higher interest rate than Treasury bonds with the same maturity date. The additional interest serves to compensate investors for the additional risk of default.

According to The Wall Street Journal, the spread on junk bonds has narrowed from almost 20 percentage points last fall to just 7.6 percentage points today. Although that's still a significant spread by historical standards -- the average figure is just 5.6 percentage points -- it shows just how much investors have bid up the prices of these bonds lately.

Big gains are done
The problem, though, is that bonds can only rise so much. Back in October, the WSJ reported that bonds on Ford Motor (NYSE:F) had jumped from $0.125 on the dollar at their February/March lows to $0.72, and that MGM Mirage (NYSE:MGM) bonds had tripled in value since the rally began. Those returns compare pretty favorably with how the stocks of those companies have fared this year.

But although shares can keep rising indefinitely, there's an upper limit on how much a bond can appreciate. Take a look, for instance, at these recent prices on high-yield corporates:

Source: Wall Street Journal. Prices quoted in percentage points of par value as of Nov. 27, 2009.

Because bond investors know they won't receive more than the par value of the bond at maturity, you typically won't see their prices rise too far beyond 100% of their par value. On the other hand, if a business thrives, stock investors can continue to see huge gains in the future. And although junk bond owners will receive healthy interest payments, they may pale in comparison to the huge returns that shareholders often see.

On the other hand, if recent optimism turns out to be wrong, then bondholders could find themselves in exactly the same hole they were in earlier this year. As investors in GM and Chrysler can attest, the credit crisis proved that corporate bond investors found little or no protection from the fact that they were higher in their company's capital structure than shareholders.

Stick with stocks?
With interest rates in safer securities so low, you can expect demand for high-yield junk bonds to remain strong for some time. Yet you need to ask whether you're really getting compensated for the risk you're taking on. Given the limited upside and potentially huge downside of junk bonds, you might actually be better off taking the arguably bigger risk of buying stock -- simply because the rewards are potentially so much higher.

Selling one stock cost Joe Magyer a fortune. Find out how Joe thinks he'll make up for those missed gains.