Some Junk Bonds Look Safer Than Stocks

Editor's note: This article originally appeared on RealMoney.com

High-yield bonds are offering attractive yields when compared with other interest-bearing bonds. Many high-yield funds are offering yields of more than 10% and are vastly outperforming comparable T-bonds, which yield about 3%.

To review, a high-yield bond by definition is any corporate bond that has a rating of BB or lower. BBB and A or higher are investment-grade ratings. High-yield bonds are also known as junk bonds because of their higher default rates.

As noted in an article on preferred stocks, there is a hierarchy in case of a bankruptcy: bank debt, senior debt, junior debt, accounts payable, preferred stock and then common stock. In bankruptcy court, usually the senior debt holders and junior debt holders fight over the value of assets.

Let's pretend that a company goes into bankruptcy, and its main asset is a factory that's worth about $300 million. Let's also assume that the face value of the senior bonds is $400 million and the junior bonds are $200 million. The senior bond holders will hope the judge determines that the factory is worth as low a price as possible. This way, they will get more of the factory and may be able to exclude the junior debt. The junior bond holders hope that the factory gets as high a valuation as possible. This way, they will get more for their bonds. After court, the bonds are converted into stock. Then, these classes become equity holders. So you can see why junk bonds yield more than safer bonds.

The problem with junk bonds for individual investors is that size matters. Most junk issues must be bought in large blocks -- often times $1 million. Trades are illiquid, too. It's much easier to buy a fund than to trade individual high-yield bonds.

The Vanguard High Yield Fund (VWEHX) is an excellent place to start. Its fees are only a paltry 0.25%, and its yield is 10.17%. Over the past year, it dropped 16.19% in value. That's pretty good compared with the S&P 500, which dropped 38% over the same time frame. That's a 22% outperformance. Who says that junk bonds are risky? They are -- just not as risky as stocks.