by Archie M. Richards, Jr., CFP^®
April 5, 2004

Junk bonds and mutual funds of junk bonds have about the same risk as stocks. But over the long run, they return less. Don't bother with the junks. Buy stocks instead.

Junk bonds are the IOUs of corporations that have a reasonable possibility of default. Unlike good-quality bonds, where the primary risk is changes of interest rates, the primary risk for junk bonds is default.

Approximately 20 percent of all U.S. corporate debt is considered junk. Companies with junk bonds include J.C. Penney and Xerox. The industry with the most junk debt at this time is airlines.

Bonds are rated according to the likelihood of repayment. The four ratings of investment-grade bonds are AAA, AA, A, and BBB. Then come the junk bonds: BB - somewhat speculative; B - very speculative; CCC - substantial risk of default; CC - may be in default; and C - in default.

As a general rule, the greater the risk of default of a particular bond, the higher the interest yield. Generally, the degree of risk of junk bonds is measured in relation to that of Treasury notes and bonds (which are considered completely safe). According to Lehman Bros., the yield of the average junk bond is currently 3.90 points higher than the yield of the average Treasury. The difference is called the "spread. The more junk bonds are considered risky, the wider the spread.

Let's say a hypothetical company, International Gadget, borrows money from the investing public and offers in return a 10-year bond, rated BB. The company is troubled, which is why its bonds are considered junk. The yield on the bond is 5.5 percent.

But assume that, five years later, the company suffers additional difficulties. The risk of default increases, and the rating is lowered to CCC (substantial risk of default). The bond's price would fall from $1000 to something like $600. The interest payments remain the same, but with the price so much lower, the yield would then be about 18 percent. The bond is then a whopping bargain, providing, of course, that the company doesn't go busted. If it does, the investors might not receive their money back at all.

The prices of junk bonds tend to move up and down with stock prices. In 1988, for example, the stock market was high, and junk bonds were very popular. The spread between the yields of junk bonds and Treasurys was narrow, only about 2 points.

The prices of both stocks and junk bonds then fell sharply. Two years later, in 1990, junk bonds sold for only about $350 per $1000 bond, yielding approximately 35 percent a year. The spread reached an amazing 11 points. The primary cause of this junk-bond panic was ill-advised and heavy-handed policies of the federal government. I wish I had space to tell that story.

Don't be fooled by the names of mutual funds that buy junk bonds. The word "junk" is avoided. The funds prefer more enticing terms like "high yield," "high income," and "high opportunity." But despite the names, these funds are risky. If you're thinking about purchasing a mutual fund of bonds, find out from the fund itself or from Morningstar the average rating of the bonds held in the portfolio. If the average is BB or lower, stay away.

The risk of junk bonds is about the same as that of stocks. But counting dividends and appreciation, stocks in the long run earn considerably higher returns. Also, the dividends on stocks are taxed at lower rates than the interest on bonds.

Don't bother with junk bonds. Spread your money to other sectors, say, 30 percent U.S. stocks, 30 percent foreign stocks, 20 percent real estate investment trusts, and 20 percent investment-grade bonds. Such a portfolio currently earns about 4 percent income. If you need income of 5 or 6 percent, take it. The appreciation of the stocks over time will more than make up for your spending small amounts of principal. The growth will make you a winner.

Are you willing to accept the risk of junk bonds? Put your money into stocks instead.