Junk bonds

Junk bonds

LBOs and debt levels

This of course is the thinking behind the leveraged buyouts of the late 1980s. There were obvious excesses in that market, but almost every company should have some debt in addition to equity.

The reason is simple. Interest paid to bondholders is tax deductible for the corporation, while dividends paid to stockholders are not.

How higher debt levels increase stock prices

Assume a company requires $100 in total capital. It can acquire this capital through a mixture of bonds or stocks. Let's say the company is financed entirely with $100 in stock. Further assume the company makes $10 in pretax profits, and the firm has a 40 percent tax rate. Thus, the after-tax earnings available for dividends to stockholders is only $6.

Now assume the company is capitalized with $100 in bonds. The bonds promise to pay $10 in interest, which is exactly equal to the firm's earnings.

After deducting the firm's interest payments from it's pretax earnings, the firm has a taxable income of $0. In this case, the providers of capital get all of the firm's $10 in earnings, and the government doesn't get anything in taxes.

Of course this example is pretty strained. The latter case with 100 percent debt capital leaves the company operating with no tolerance for error. If the company doesn't earn enough to cover the interest payments, the company can be thrown into bankruptcy.

Still, I hope you see that because of the deductibility of interest payments, there is an advantage to a company having a manageable load of debt. By using tax-deductible debt, the providers of capital get more money, and the government gets less.

This brings us to the world of junk bond investing. Junk bonds, also called high yield bonds, used to be a small part of the bond market, but changes in financial markets and the 1986 Tax Reform Act made the issuance of low-grade debt more attractive. Now junk bonds constitute about 25 percent of the total corporate bond market.

Junk bonds have higher interest rates, shorter maturities

Junk bonds of course carry more credit risk than investment grade bonds. But because most high yield bonds have a maturity of less than 10 years, they normally carry lower interest rate risk than long-term US Treasury bonds.

Also, you're usually compensated for the increased credit risk associated with junk bonds. Junk bonds generally yield about 2 percent more than investment grade corporate bonds.

The junk market isn't efficient - players are left out

Finally, since many institutions like commercial banks cannot invest in junk bonds, the number of buyers of these securities is artificially limited. With buyers limited, issuers have to pay more than they would otherwise have to pay. This should work to your advantage.

There are, however, a few things to consider when investing in junk bonds. First, junk bonds often have been called stocks in disguise. This isn't exactly true, because with a bond, you have a contract between you and the issuer. No such contract exists for stockholders.

Junk bonds behave like equities

But high yield bonds sometimes behave like stocks. When the economy is down, stock prices fall because companies' earnings drop in the recession.

Likewise, the prices of junk bonds also fall in a recession. With reduced earnings, the issuing companies are less able to pay their debt obligations. As fears of bankruptcy rise, junk bond prices fall.

Note this price movement is the opposite of a US Treasury bond. Treasury bonds have no credit risk, but face inflation or interest rate risk. As interest rates drop in the recession, US Treasury bond prices rise.

Use junk to diversify your bond holdings

So junk bonds offer a good way to diversify your total portfolio. To get a good, diversified portfolio you want a mixture of assets that zig when other assets zag. Of course if you could switch from the losers to the winners, you'd make a lot more money, but in practice this is difficult and no one has a great record in switching like this.

So instead of trying to time the market, it's probably better to maintain a diversified portfolio of uncorrelated assets. Because of their hybrid nature as a cross between stocks and bonds, and because of their attractive current yields, you should consider putting perhaps 20 percent of your total bond holdings into junk bonds.

I mentioned before that some people think of junk bonds as stocks in disguise. Their prices sometimes move in tandem, but junk bonds and stocks generate different forms of income.

Most of your return from stocks will be capital gain income, while junk bonds offer high interest income and usually a slight capital loss over time.

Junk bonds provide a high current yield, this high yield compensates you for the fact that you'll probably lose some principal due to bankruptcies. This form of return, however, will pose a slight problem with the taxation of junk bonds.

Taxes are a problem for junk bonds

Taxes are a problem for high yield bonds because the interest payments are fully taxable, and there's little hope for favorable capital gains treatment. To reduce your tax liability, you should place most of your junk bond investments inside your retirement accounts or otherwise shield your earnings from taxes. See my tape on mutual fund investing for more information like this on investing to minimize your tax burden.

Finally, you'll almost always want to invest in junk bonds through a mutual fund. You probably can safely buy individual US Treasury bonds, but don't buy junk bonds individually.

If the issuing company files for bankruptcy, you could easily lose half or more of your investment. It's better to invest with a mutual fund which will diversify your investment among 20 or more companies.