BONDS ARE IN THE NEWS again. Everyone’s talking about Series I savings bonds and Treasurys. But what about corporate bonds, both investment-grade and junk?
Nine years ago, we started following Marc Lichtenfeld’s investment service that recommends corporate bonds. When my husband suggested we try it, I asked, “Aren’t corporate bonds junk bonds?” Forgive the holiday reference, but I had visions of Michael Milken dancing in my head.
From the beginning, my husband was all in. He was intrigued by the high rates corporates would pay and the opportunity for diversification. I was concerned about the risk. Once we got started, though, I found a lot to like.
Corporate bonds carry ratings that help distinguish their creditworthiness. Three credit rating agencies—Moody’s, Standard & Poor’s and Fitch—sort corporates into investment grade, speculative grade, likely to default and defaulting. Each tier has a corresponding letter grade, from AAA to D.
Bond buyers can look up the gradations among the three rating agencies to understand what each rating means for any given bond. In general, a top rating of AAA is reserved for U.S. Treasurys and the strongest blue-chip companies. Investment-grade corporate bonds can get grades ranging from AA+ to BBB-. Anything lower is speculative or not investment grade—junk, in other words.
We compromised by buying investment-grade bonds at first. Gradually, we ventured further into the depths of junk, even buying C- and D-rated bonds as time went on. These are the bottom rungs of junk. A grade of D, for example, usually signifies “in default.”
How, then, have our junk bonds held up? Surprisingly well. For a risk-averse investor like me, a crucial selling point was their relatively low default rate of 2.5% to 3.5%.
High-yield bonds have also posted sturdy returns, according to Bloomberg data cited by money manager Hotchkis & Wiley. The average annualized return on high-yield bonds between 1986 and 2021 was 7.3% during periods of rising interest rates and 8.5% in periods of falling rates. Investment-grade bonds, by contrast, returned less—just 1.2%—in periods of rising rates and more—9.9%—in periods of falling rates.
Why did we buy individual bonds rather than bond funds? When interest rates rise, as they have this year, the share prices of bond funds fall. The market discounts the lower-yielding bonds in the fund’s portfolio until their yield equals the higher rates on offer by newly issued bonds. The share-price decline can be even larger for closed-end funds that use leverage, or borrowed money, to juice their returns.
The price of individual bonds, of course, also falls when interest rates rise. But we aren’t bothered. Our intent is to hold our bonds until maturity. That way, we collect the interest from bond coupons until we are paid back our principal at maturity. Occasionally, a bond we own may get repaid early—or “called.” If we’re lucky, the bond in question gets redeemed at a premium to its current market price.
Our bond investment service has guidelines that match our objectives. Bonds are selected based on “coverage”—the ability of the company to generate sufficient cash flow, or which has adequate funds, to make coupon payments during the time we’ll own them. In addition to the interest payments, paid at a minimum every six months, we can occasionally buy bonds at a discount, which can give us a capital gain if their prices recover.
Today, we have a portfolio of bonds that yield anywhere from 3% to 16%. The higher payouts mean higher risk. Two-thirds of our bonds are non-investment grade, or junk. Our current portfolio includes bonds maturing every year for the next five years.
Overall, we’re doing well, although we do own some disappointments, such as Revlon. Did you think we wouldn’t have some clunkers amid all this junk? There’s lots of bad news about Revlon. From the start, it was called distressed. Then came the bankruptcy filing. Then there was good news. Revlon was paying its bond coupons even in bankruptcy, so through it all we’ve been getting our scheduled interest payments.
We have no idea if Revlon can make it through intact, or whether it’ll be sold off or even liquidated. We did know what we were getting into when we bought, so we kept our investment small.
You could equate our fondness for junk bonds with junk food. We don’t eat it often, but when we do, we enjoy it. We’re usually aware of what we’re doing—and we try not to overdo it.
Sonja Haggert is the author of Invest, Reinvest, Rest. You can learn more at SonjaHaggert.com. Follow her on Twitter @SonjaHaggert and check out her earlier articles.
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Pricing thinly traded bonds can be…challenging. No guarantee the bond pricing which the broker is quoting will be fair
Sonja – Although not much of a bond guy and never a junker, I am aligned that buying bonds and holding until maturity is my far prefered approach rather than investing in bond funds particularly when the Fed has clearly articulated an intent to increase interest rates.
Sonja, I enjoyed the article very much! It’s nice to see how others invest from a point of view that I hadn’t considered, or rather for my own lack of understanding because the only bonds I have are in a balanced fund.
Interestingly, I’m currently reading Alex Green’s updated version of “The Gone Fishin’ Portfolio” which is mostly about a diversified portfolio. They have a $49 offer for a one year subscription to the Oxford Communiqué newsletter. I have never read one of their newsletters, but if you have read this particular one, may I ask your opinion of it?
Olin, I’m happy to give you my opinion; I’ve been reading Alex’s newsletter for at least 20 years. It was recommended to my husband and me by my father-in-law, who introduced us to investing. We have found it to be very beneficial from the standpoint that his philosophy is to buy and hold. Best of all, he sends an alert to sell when fundamentals change. To us, that is the very best feature of all. It’s relatively easy to find a stock to buy, but not so much when to sell.
Thank you for your honest opinion!
Sonja, you mention that junk bonds have a relatively low default rate of 2.5% to 3.5%. Is this an average over some period of years? What was the default rate during the Financial Crisis years of 2008-9? If we have a recession next year, do you expect the default rate to rise? And how would that affect your returns?
You also mention that if one of your bonds gets called early, and you’re lucky, it may be redeemed at a premium. Correct me if I’m wrong, but when a bond is called, isn’t the issuer obligated to pay you just the face value of the bond? To enjoy a premium over the purchase price, wouldn’t you have to sell the bond in the secondary market?
Hi Philip, The 2.5%-3.5% is an average. You can find default rate information in the article referenced in paragraph eight in the Bloomberg link. Default rates peaked during the 2007-8 financial crisis at 12%. In 2021 they were at 0.5%. Yes, the thinking is they would rise again in a recession.
Our returns are occasionally affected, but we would only buy junk bonds with advice from Marc Lichtenfeld at the Oxford Club. He has proven to be a reliable resource, finding bonds to buy and telling us when to get out.
When a bond is called, the issuer can pay above par. You can find this and other information on the Fidelity Website.
Vanguard’s BND ETF expense ratio = .03%
Marc Lichtenfeld’s
One Year of Oxford Bond Advantage for Just $4,000!
Ouch!
Christopher, as Olin suggests in his comment, there are times when The Oxford Club runs specials. You may also want to contact them directly for a sample if you’re interested.
High yield bonds can be a good income tool, but I’d rather own a fund that spares me from making individual credit risk decisions and which can provide greater diversification. I would also note that the value of high yield bonds has generally degraded over time as interest rate have declined. They are also not immune to adverse market or economic news as has been amply demonstrated in 2002, 2008 and most recently in early 2020. Had you bought high yield at any of these inflection points, you’d likely be a happy investor, but as a long term hold to maturity investor, maybe not so much. At a minimum, a healthy exposure to the S&P 500 plus high yield would likely generate much higher total returns.
I was working on the tax side of public accounting when cost-basis reporting underwent sweeping changes back in 2008 as part of the Emergency Economic Stabilization Act. Under those regulations, financial service firms and intermediaries began reporting adjusted cost-basis information to
both investors and the IRS on Form 1099-B.
Brokers generally adopted default options regarding the reporting of amortization of bond premiums and discounts in the tax statements and year end statements the client receives.
To simplify their individual tax reporting in regards to bonds many taxpayers simple stick with a bond index fund or EFT in their taxable accounts or hold individual bonds inside a IRA type account. Except for I-bonds that has been my choice to avoid tax complexity as I have never been much of a bond investor.
Good and timely article as meaningful interest rates will again attract investors who will be well served by becoming knowledgeable of the tax reporting requirements before jumping into the pool.
I’ve always thought “junk” was a terrible name for high-yield bonds. To my ear it sounds like they won’t be repaid, which is, more often than not, not the case.
I have Vanguard Total Bond Fund in my IRA. I noticed it didn’t include junk bonds, and thought well it’s not really “total”. So I bought Vanguard High-Yield Corporate Fund. It’s 15% of my bond portion, 8% of my IRA portfolio. As retirees the monthly dividends from both were welcome income. With a full year of SS for 2023, I may decide to just reinvest. Enjoyed your article, thank you.
Interesting article. Do you have much trouble finding non-callable bonds to purchase, or is it much of a problem when called?
Mark, We don’t look for callable bonds because we intend to hold them to maturity. If we bought the bond at a discount, we would probably accept the offer, which is usually to our advantage. If we bought the bond at par or above, we may find it better to hold it to maturity.