3 Smart Ways to Profit from Junk Bonds

Say the term “junk bonds” and you will get several reactions from investors. First, market veterans will recall the heady days of the 1980s when junk bonds first became in vogue as a capital-raising tool.

Secondly, some investors will look at you with disbelief, thinking junk bonds no longer even exist. And newer market participants might have no idea what you’re talking about.

This article will explain junk bonds and provide three ways to capture profits from these little-understood financial instruments.

What Is A Junk Bond?
Junk bonds got their start in the 1970s when they were used to finance companies that could not qualify for investment-grade bonds. Also known by more forgiving moniker “high-yield bonds,” junk bonds truly revolutionized finance, as they enabled firms not considered traditionally bankable firms to raise capital.

Junk bonds, like all bonds, are an IOU from a business that includes how much is owed, the maturity date, and the interest (coupon) that is paid.

The significant difference is the coupon, or interest rate, charged.

Junk bonds command a much higher interest rate due to the poor credit ratings of the companies using them.

Like with any type of investing, risk equals reward, and due to the higher risk of junk bonds, the potential reward is high.

An excellent way to think about it is like a personal credit score. If you have a high credit score, you will pay less interest on loans since the perceived risk to the lender is less. As your credit score drops, your interest rate will increase because the risk to the lender increases. This is why junk bonds yield higher than regular bonds for investors.

Right now, junk bonds have fallen out of favor due to climbing bond yields. Short interest is at an all-time high for junk bond ETFs, with over $7 billion borrowed to short. Being a contrarian investor, I see this spike in short interest as a powerful bullish signal for junk bonds.

Now that we have a basic understanding of junk bonds, how can regular investors profit from them?

Junk bonds are a great addition to your portfolio, rather than a singular investment. They can add diversification and long-term income, but are simply too risky to have much exposure with your capital.

My suggestion is to allocate no more than 10% of your risk assets to the junk bond market. However, everyone’s situation and risk tolerance is different. Regardless of what you choose, be sure to stay within your risk parameters when investing in junk bonds.

Here are three ways to profit from junk bonds:

1. SPDR Bloomberg Barclays High Yield Bond ETF (JNK)
The JNK ETF is the most popular way for retail investors to access the junk bond market. It boasts nearly $9 billion in assets and is among the broadest in the segment.

Launched in 2007, JNK is structured as an open-ended fund with a 0.40% expense ratio. It seeks to provide returns reflecting those of the Bloomberg Barclays High Yield Very Liquid Index.

Holding 967 junk bonds with 86% industrial, just under 10% finance, and only over 3% utility sector exposure, JNK’s average coupon for its holdings is 6.23% with a six-year average maturity. The ETF itself is currently yielding 6.37% .

2. MassMutual Premier High Yield Fund (DLHYX)
This mutual fund invests in unrated and below-investment-grade-rated bonds. The fund holds around 188 junk bonds and just under $500 million in total assets under management.

DLHYX has returned around 8% on average over the last 15 years. The mutual fund structure makes the MassMutual Premier High Yield Fund an ideal instrument for long-term buy and hold investors.

3. ProShares Short High Yield ETF (SJB)
SJB is one easy way to short the junk bond market. If you believe the crowd and are bearish on junk bonds, consider this ETF to profit from the market’s downside.

Active, short-term investors may want to consider a leveraged short junk bond ETFs to increase yield. One example would be the Direxion High Yield Bear 2X Shares (HYDD).

Risks To Consider: Do not underestimate the ultra-high relative risk of junk bonds. While spreading the risk via diversifying with ETF lessens the risk, risk remains high. As I said before, only use junk bonds as a way to add diversification to your portfolio and allocate wisely!

Action To Take: Whether you are bullish or bearish on junk bonds, consider adding exposure to junk bonds to your portfolio via a mutual fund or ETF.

— David Goodboy

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Source: Street Authority