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In the financial markets, investors who take risks often reap the biggest rewards. Although most of the bond market has been among investors' favorite places for new money in recent months, junk bonds just might be giving you enough potential reward to justify their risk.
What makes a bond junk?
Typically, a bond involves making an initial investment in exchange for the promise of getting your money back at a future date. Along the way, the company or other entity that issues the bonds pays you interest at regular intervals, often twice a year.
What distinguishes investment-grade bonds from speculative or high-yield bonds (also known as junk bonds) is the rating they receive from rating agencies. Standard & Poor's, Moody's, and Fitch are the most popular rating agencies for bonds, and while their scales are slightly different, what it comes down to is this: Ratings of BBB- or Baa3 or above earn you investment-grade status, while BB+/Ba1 ratings or below are considered junk.
Junk bonds should always trade at a premium to investment-grade bonds. But the size of the spread between Treasuries and junk bonds rises and falls with market conditions. According to Barron's, that spread is at a historically high level: 7.1 percentage points, almost three percentage points higher than historical default rates would imply was the correct rate.
No free lunch
Now before you start salivating at interest rates in the high single digits, remember to look at the other side of the risk-reward equation. The companies issuing junk bonds aren't necessarily ones you'd feel all that confident lending money to at the moment. Just looking through the holdings of one junk bond ETF exposes a number of companies with big obstacles to overcome.
For instance, CIT Group (NYSE: CIT ) has been through one bankruptcy recently and still has almost five times as much debt as equity. AIG (NYSE: AIG ) has struggled to sell off assets in order to repay huge amounts to the U.S. government, and while renowned investor Bruce Berkowitz believes there will be substantial assets left over at the end of the day, others fear that even bondholders won't get repaid in full.
Community Health Systems (NYSE: CYH ) owns or leases more than 120 hospitals, but has to deal with the uncertainties of health-care reform while holding its own against health insurance companies eager to cut their costs by denying payment for the services its hospitals provide.
Even more credible issuers raise concerns. For instance, Ford Motor (NYSE: F ) and Sprint Nextel (NYSE: S ) have both seen positive signs in the rebounding economy, but there have been setbacks as well, and each has enough debt to make bondholders nervous.
Bondholders are betting on one of two things: either these issuers will avoid bankruptcy at least long enough to repay these bonds in full, or if they do default on the loans, they'll still recover all or most of their investment. That's not a sure thing, which is why investors get that extra interest. But even if default rates rise, you're still getting that three-percentage-point margin of safety from extraordinarily high spreads.
Where's the junkyard?
If you think junk bonds belong in your portfolio despite the risks, you have a few different options. Many discount brokers have bond desks where you can buy individual bonds in quantities as low as $1,000. With individual bonds, you can ensure you own only the bonds you're most confident about.
Alternatively, the ETFs iShares iBoxx High-Yield Corporate Bond (NYSE: HYG ) and SPDR Barclays High Yield Bond (NYSE: JNK ) give you a wide variety of speculative-grade bonds with attractive yields. The SPDR fund has a current yield over 9% while the iShares fund's yield is 8.7%.
Junk bonds aren't for everyone, especially if you think that the economy will start to decline again from its slow recovery. But with alternatives in the bond market paying less than ever, junk bonds are worth a second look simply because of the pessimism their prices imply.
Tired of settling for junk? Fool Alex Dumortier names the one high-quality stock that belongs at the top of your list.
Fool contributor Dan Caplinger gets down with his junk. He doesn't own shares of the companies mentioned in this article. Moody's and Sprint Nextel are Motley Fool Inside Value recommendations. Ford Motor and Moody's are Motley Fool Stock Advisor selections. Motley Fool Options has recommended a stock repair strategy on Moody's. The Fool owns shares of iShares iBoxx $High Yield Corporate Bond ETF. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy is the no-risk path to what you need to know.