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
, 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
, 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.
The fund has some familiar names:
. Sure, these are risky, but less risky than the underlying stocks.
What are risky are financial junk bonds. Investment banks are levered to their eyeballs, and who knows what their assets are? Freeport-McMoRan has $42 billion in assets and $13.5 billion in tangible equity. That's a ratio of 3.23. What is scary is
, which has $2 trillion in assets and $63 billion in tangible equity (according to Yahoo! Finance). That's a ratio of 32.5! With Freeport, at least you know that if it goes bankrupt, you have a claim on its copper and gold mines. With Citigroup, you get a claim on a portfolio of credit card receivables. Yuck!
iShares has a high-yield ETF, the
iShares iBoxx High-Yield Corporate
. Its expense ratio is a little higher at 0.5%, and it has a yield of 11.18% (according to Yahoo! Finance). Like the Vanguard fund, this ETF holds many non-financial junk bonds, including
Is now the time to buy these funds, or is it too early? Tough call. There is basically a 7% spread between the yield on these funds and the comparable Treasuries. But if the Treasuries rise in yield, that gap will close. Also, if many of these bonds drop in value, it will kill the funds' net asset value.
There is definitely risk. However, one can say that the bonds will be a lot less volatile than the common stocks of the likes of
Bank of America
. Whether you think it's too early or that now is the time, these funds offer a great way to make a profit in these crazy markets.
At the time of publication, Osborne had no positions in the stocks mentioned.
Holmes R. Osborne III is a private money manager, founder of investment newsletter
and frequent author of financial columns. He has a degree in finance from the Martin J. Whitman School of Management at Syracuse University and is a CFA charter holder. Osborne is a member of the Pacific Council on International Relations, Malibu Rotary, Business Forum International and was formerly on the board of the L.A. National Association of Business Economists. He spoke this year at the fifth annual Value Investor Conference.