Don’t Be Scared to Purchase Individual Junk Bonds – Redux

By: The Financial Lexicon

(October 1st, 2012) As an author of financial articles, I am accustomed to receiving all sorts of feedback on my writings.  Occasionally, a reader may be confused about something I write, and I respond in an attempt to provide clarification.  This article represents such an occasion.

In response to my recent article, “Don’t Be Scared to Purchase Individual Junk Bonds,” Tom Brakke, author of the blog, “the research puzzle,” wrote a piece called, “be scared.”  In his piece, Brakke misunderstood the purpose of my article, that investors should not be scared to purchase individual bonds with certain credit ratings, and instead implied that my piece acted as a market call to buy individual bonds with certain junk ratings at today’s levels.  I made no such market call in my article.  My article was meant to present facts about historical default rates in the high-yield bond market and state that investors should not shy away from considering individual bonds for their portfolios.  Of course, timing matters, and investors will each need to do their own due diligence about whether any particular moment is the right time to purchase any particular individual bond.

In his blog post, Brakke began by presenting a chart of the total returns of two high-yield bond funds during 2007 and 2008. Naturally, the total returns of those funds were quite awful in the second half of 2008, in a similar way that equity funds and commodities experienced atrocious returns during the same time period.  It appears the chart was presented in order to show investors just how bad it could get in terms of unrealized mark-to-market returns on high-yield bond funds.  The scary looking chart is just one of many reasons that individual bonds are something to consider for your bond portfolio, as opposed to a bond allocation 100% in funds.  After all, it is possible the fund never returns to the levels at which you purchased it, whereas an individual bond will mature at par (assuming no default).

On numerous occasions in my articles, I have advocated that investors purchasing individual bonds should do so with the intent to hold the bond to maturity.  Doing so will help you avoid getting, as Brakke puts it, “puked out” of your position.  This is because your bond will eventually mature at par (assuming no default), thereby affording you the comfort of ignoring the illiquidity and unrealized mark-to-market losses that come with bear markets.

Besides, perhaps unwittingly, bolstering the case for considering individual bonds, Brakke also stated in his article:

“Not mentioned in the article is that it’ll cost you quite a bit in transaction costs (seen or unseen) to buy the bonds and if you feel like selling them you might find that there are either no bids or that you get clipped very hard trying to get out.  In addition, many bonds are callable, which means your upside is limited but your downside isn’t.”

I would like to share three thoughts concerning the preceding paragraph:

1. Depending on your broker, you can now purchase individual bonds for as little as $1 per bond with minimums as low as one bond.  For the buy-and-hold-to-maturity investor who is confident in the creditworthiness of a company and wants to avoid giving up part of his or her yield to a fund manager via a yearly expense ratio, today’s low bond commissions at several retail brokers are something to explore further.

2. As Brakke points out, many bonds are callable.  But many bonds are also not callable.  Additionally, bonds have different types of call features.  Some of those features make it more likely for a bond to be called, and others make it less likely.

To address Brakke’s claim that call features limit your upside but not your downside:  This may be relevant to a bond trader, but for a retail investor buying with the intent of holding to maturity, this is a completely irrelevant point.  Such investors are not buying bonds for capital appreciation.  His point on call features seems like the typical red herring used by financial market pundits who like to bash bonds.

As an aside, I would be curious to know what Brakke was thinking with regard to the “downside” not being limited.  For an investor owning an individual bond in a cash account, how much money in addition to the principal is Brakke implying is at risk?

3.  I agree that “unseen” transaction costs are something of which to be aware when purchasing individual bonds.  Investors interested in this topic might enjoy my article, “Are You Paying To Much For Your Bonds?

While I never offered an opinion on the high-yield bond market in my article, “Don’t Be Scared to Purchase Individual Junk Bonds,” I’ll share some thoughts now.

I do not think this is a great time to go all-in on high-yield debt.  Despite the fact that spreads are trading at levels that would historically not represent a top in high-yield bonds, spreads are also not at levels that would represent extreme value.  I think investors in the high-yield market should be very selective and very patient at today’s levels.

There are opportunities that have presented themselves in recent weeks despite the strong rally in high-yield bonds of late.  And I would venture to guess there will be additional opportunities in the weeks ahead.  One advantage as an individual bond investor is that you can search for those individual opportunities without having to worry about whether the market as a whole is trading at a level that would make a high-yield bond fund a great value.  If the credit risk, duration, and yield on a bond are to your satisfaction, and you are willing and able to hold the bond to maturity, don’t let financial pundits scare you out of an investment that will help you attain your financial goals.

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