The Hot Alternative to Dividend Stocks

For years now, investors have turned to dividend stocks to get the income they need. With other traditional sources of income largely falling flat and failing to deliver enough cash flow, especially for retirees, stocks with impressive dividend yields have helped many people bridge the gap between the income they need and what standard bank accounts and other safe investments provide.

But with all the hype about dividend stocks, some investors are looking for ways to diversify beyond them. One popular choice has been corporate bonds, especially high-yielding bonds. But with the appetizing nickname of "junk" bonds, are corporates really a smart play -- or an invitation for disaster?

Why one investor's junk is another's treasure
At first glance, the appeal of corporate bonds seems to be just another example of how desperate investors often stretch to get as much yield as they can from their portfolios. After all, compared to Treasury bonds, corporates come with default risk -- if something happens to a company that issues bonds, then bondholders may end up losing part or all of their investment, just like regular shareholders do. The trade-off is that corporate bond investors earn extra yield that's intended to compensate them for the additional default risk.

Recently, though, there have been some signs that the bond market is overcompensating investors for that risk. A study from Babson Capital Management cited in Barron's noted that with default rates on high-yield bonds at roughly half their historical levels, the current extra interest that junk bond owners are getting implies that those default rates will nearly triple from their current levels.

Another analyst pointed out that as rates on Treasuries and most other bonds have fallen, junk bond yields have actually gone up. That's extremely useful for investors who needed that additional income.

The other side of the trade
Before you line up to buy junk bonds and other corporate debt, though, consider the other end of the supply-and-demand equation. According to Moody's, U.S. companies will need to refinance about $1.3 trillion in maturing debt over the next five years. More than half of that is junk debt, split between corporate bonds and bank-provided credit.

Also, prices have already jumped substantially, prompting new issuers to come to market sooner than later. Petrobras (NYSE: PBR  ) plans to sell about $6 billion in the near future, as it seeks to raise capital to develop its offshore assets, which carry the challenge of ultra-deepwater drilling. Goldman Sachs (NYSE: GS  ) was able to lock in a 5.3% yield on 10-year notes last month. That's a big spread to Treasury yields below 2%, but for an institution that still faces uncertainties about the global financial system, the premium is understandable. JPMorgan Chase (NYSE: JPM  ) got an even better deal, with a 5.1% yield on 30-year debt to help it lock in cheap capital for decades in light of the potential for dramatically higher interest rates down the road.

Moreover, when you look at some corporate bonds, the yields are only attractive compared to rock-bottom rates on Treasuries. Kroger (NYSE: KR  ) issued a five-year note for less than 1.8% in yield, despite the company having only a BBB rating. And even with the challenges that the Japanese earthquake and tsunami last year raised, newly issued Toyota Motor (NYSE: TM  ) debt yields only 1.7%.

Be careful out there
Corporate bonds in general and junk bonds in particular are getting a lot of attention. But before you invest in the area, make sure you fully understand the risks and rewards involved. Some corporates -- even junk bonds -- are a good deal, but others have traps for the unwary. If you can't tell the difference, then you'd be better off leaving the space to those who can.

A key part of a secure retirement is having the income you need. The Motley Fool's latest special report looks at several stocks that have the features you need to have a rich retirement. It doesn't cost a dime -- but grab it today while it's still available.

Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance. You can follow him on Twitter here.

Fool contributor Dan Caplinger owns his share of corporates through mutual funds, but he doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of JPMorgan Chase. Motley Fool newsletter services have recommended buying shares of Goldman Sachs and Petroleo Brasileiro. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy is our bond to you.


Read/Post Comments (9) | Recommend This Article (56)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On February 01, 2012, at 5:56 PM, Deibster wrote:

    I consider these bonds to be a speculative investment and limit the fraction of my portfolio invested in them. Despite that warning, I have done well with them. I bought Ford bonds in 2009 for 80 cents on the dollar. They matured in '11, paid full face value plus almost 8% interest, which was about 10% on my original investment.

    I currently own Sallie Mae and GMAC bonds. I paid less than par value for them; they have increased in value over the past year. I'm not sure that I would buy more at today's price. One good research tool is QuantumOnline.com.To successful investing! Deibster

  • Report this Comment On February 01, 2012, at 7:35 PM, yragca wrote:

    In general I do not buy mutual funds. But isn't this a place to do some research on the high yield funds, find good managers with good track records, and let them do the research. They have the time and skills to do the analysis, hopefully anyway, and they buy enough bonds to diversify. David Rosenberg, generally regarded as a bear, feels that a bad recession is built into junk yields, and that there are good investment opportunities. I agree, but don't have time to do the homework. And 7%+ yields build in a nice cushion for some defaults.

  • Report this Comment On February 01, 2012, at 8:15 PM, PKB54 wrote:

    First, let me say that I read, enjoy and am generally enlightened by Fool articles. Second, this article raises a good thought - and one that I have personally addressed in my portfolio with a couple of funds - but there isn't the typical recommendation to look into specific issues or vehicles. I was hoping to be sent looking into a couple of alternatives that I might/probably have missed.

  • Report this Comment On February 01, 2012, at 9:02 PM, cummingsr wrote:

    This is a basically useless piece. It seems that the author has a firm grasp of the obvious. I read this Motley Fool stuff frequently and I wish that the content could provide the quality that was once standard. Why waste our time with trivial observations offering little or no value added??

  • Report this Comment On February 02, 2012, at 12:39 AM, tabooma wrote:

    The reason these companies are rushing to market is to take advantage of Fools who listen to this line of investment. If it were not to their advantage, they would not come to market. Now, is it to your advantage? Think! Consider!! Are Fools always right?

  • Report this Comment On February 02, 2012, at 5:56 AM, dbtheonly wrote:

    tabooma,

    The reason companies are rushing bonds to market is that they are paying historically low interest rates.

    Very few people (and corporations are people, my friend) do things that they do not view as being in their best interest.

    So is your point the "interest rates are about to explode" argument?

  • Report this Comment On February 02, 2012, at 7:57 AM, TMFGalagan wrote:

    @cummingsr -

    Thanks for your comments. Let me just say, though, that what's trivial to you is undiscovered territory for many others. In particular, many people don't follow the bond market closely and therefore see only the reward and not the risk involved.

    best,

    dan (TMF Galagan)

  • Report this Comment On February 02, 2012, at 3:12 PM, seymore350 wrote:

    As a long-time mutual fund investor, who is now trying to scramble to aquire the income to keep me feed in my retirement, I have stumbled upon Royalty Investment Trusts. This was posted in Seeking Alpha a few months back. I was interested in Oil Trust, some paying very nice dividens. However, I am not sure how they would be handled tax wise or any other disagvantages?

  • Report this Comment On February 02, 2012, at 3:15 PM, nosocksjuststock wrote:

    I diverted $10,000 in my 401K to Vangards high yield corporate bond fund last year. It has returned 6.5 % on the dividend side and about $1,100 on the capital gains side. It stomped my s&p 500 fund. And the s&p beat my midcap and small cap funds for the second time in 25 years. If I thought this year would be a repeat of the same I would put everything into the bond fund.

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