How to Use Junk Bonds in Your Portfolio

OK, let’s come clean about something before we even start. If you were around 25 years ago when the stock market was made up of high society type people with some degree of specialized knowledge, you remember that there was no place for what we call today the retail investor. There is a 21^st century version of the stock market of old called the bond market.

Retail investors don’t dip their feet into the bond market because it’s not as liquid, it’s not as exciting as watching a screen full of red and green flashing boxes, and buying and selling bonds is much more expensive and not as efficient as trading stocks. Although bonds are traded by some, it’s not practical for the retail investor’s asset allocation. Short term trading would wipe out gains rapidly.

Because of the relative closed nature of the bond world, equity investors outside of the professional circles don’t know a lot about them or how they fit in to a portfolio. Retail investors have been fed the lie that junk bonds should be avoided at all costs. Let’s change that thinking.

What are Bonds?

For the sake of simplicity, think of a bond as a loan to a company. You give a company a certain amount of money and they issue you bonds. At some point in the future they will pay back the face value of those bonds but during the time you hold them, they pay you semiannual interest called the coupon. (It’s called the coupon because investors used to tear off a coupon in order to redeem their interest payment)

Bonds are rated by various rating agencies as to their relative safety. As we’ve seen with companies like Lehman Brothers who went bankrupt with an A rating, trusting the analysts to do your research for you isn’t the best idea.

Junk bonds are bonds issued by companies whom the ratings agencies have deemed a credit risk. There’s a chance that they may default on the bond and you’ll be left with close to nothing. In order to make up for that risk, junk bonds often pay between 6% and 10% interest and sometimes more. The risk of losing your entire investment seems like a pretty good reason to stay away from junk bonds but in reality, only about 2% of junk bonds end in default.

Let’s translate that. If you purchased bonds in 100 companies, you would earn a minimum of 6% per year on 98 of those companies and lose your investment on two of them. Those are good odds and the money you would make on the 98 would more than make up for the money you lost on the two. Stocks are far more dangerous than junk bonds.

How do I invest in Bonds?

If you’re investing for the long term and want to use your money for retirement, high yield bonds need to be part of your portfolio. If you don’t want to invest in actual bonds, invest in the ETFs. Look at JNK and HYT. Both of these are junk bond funds that pay a great dividend. Set a conservative stop to avoid any market meltdowns, sit back, and collect your nearly 9% dividend each year. These payouts will change with market conditions but you’ll still make more doing nothing than you would trying to day trade that money unless you’re one of the 10% of retail investors who is a profitable day trader.

The bond world may be a place you don’t normally explore but through the power of exchange traded funds, it’s easy to gain bond exposure that will grow your portfolio.