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How to use junk bonds in a quality portfolio

Ron Chapple/(C) 2006 Thinkstock

Dr. Charles Mossman is quick to say that he'd have no problem putting junk bonds in his portfolio. The acting dean of Winnipeg's Asper School of Business knows the products carry risks, but like many investors who were burned during the financial crisis, Dr. Mossman wouldn't mind making a few extra bucks on higher yielding investments. "Everyone wants to have a chance of making a really good payoff," he says.

Yield-hungry investors have been scooping up junk bonds, also known as high-yield bonds, for a century. But, since the recession, investors have been flocking to the market in droves.

According to the Investment Funds Institute of Canada, in the first three months of this year, investors spent about $782-million buying high-yield mutual funds, nearly 45 per cent more than the same period in 2010.

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Companies are also issuing more bonds to meet demands. In the first five months of 2011 there were nine Canadian junk bond issues and 302 U.S. issues, compared to 15 and 632, respectively, for all of 2010. Many experts think issues will surpass last year's year-end totals.

It's hard not to see why people are paying more attention to junk bonds. With 10-year Canadian government bonds yielding 3.2 per cent, and 5-year government bonds paying 2.5 per cent, it's nearly impossible to make money in the conventional bond market.

Junk bonds yield an average of about 7 per cent, or 450 basis points higher than government issues. "People are looking for some sort of returns and government bonds and high-quality corporates aren't offering," says Dr. Mossman.

While the increase in popularity is partly due to people wanting to make back money lost during the recession, the demise of the income trust market - trusts were forced to convert to corporations at the beginning of the year - has also contributed to thirst for income and the rise in issues, says John Braive, vice chair of CIBC Global Asset Management.

"To improve the efficiency of their new capital structures there has been a wave of corporate bond issues," he says.

There's no question the yield on junk bonds is attractive, but investors have to be aware that they're buying below investment grade securities, bonds with ratings between BB and D. There's a higher chance of default than with bonds rated BBB to AAA.

Hank Cunningham, a fixed income strategist with Vancouver-based investment firm Odlum Brown, says many of the corporations issuing these bonds have weak balance sheets, high debt, previous defaults or interest payments that can't be covered by earnings. "There's a risk of bankruptcy, and a higher chance of losing your principal," he says.

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People get paid more for taking on more risk, so the lower the rating the higher the yield. However, Heather Mason-Wood, a vice-president at Richmond Hill, Ont.-based Canso Investment Counsel, says people aren't differentiating between the lowest quality junk bonds and more stable high yielding securities. They simply want the highest yielding product.

"They don't realize the risk they're assuming," she says. "It's mind boggling. Two years ago people were afraid to buy anything with risk. All the sudden that's been forgotten."

As risky as junk bonds are, Mr. Braive says these securities are much safer than they've been in a long time. In 2008, yields were about 2000 basis points higher than government bonds; last summer there was a 700-basis-point difference. A narrow spread between junk and government bonds means there's less perceived risk.

Mr. Braive also points out that high-yield default rates have fallen over the last three years. During the recession 14 per cent of bonds defaulted. That fell to 3 per cent last year and Moody's is forecasting a 1.5 per cent default rate for 2011.

Despite the default dangers, there is a place for high-yield bonds in a portfolio. Dr. Mossman suggests investing no more than 5 per cent of assets in these products. He specifically cautions retirees who think high-yield bonds are their ticket back to prosperity. "If you're planning to retire on this money it's not something you want to have a lot of in a portfolio," he says. "Sooner or later some of these will default."

Investors can buy bonds themselves but it requires a lot of research. People need to inspect balance sheets, debt levels and a host of other things to make sure they're not purchasing a dud, and like most other bonds, the mark up on an individual security - about $3 more per bond than if bought in a lot - can eat into returns, says Ms. Mason-Wood.

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If investors want to purchase individual bonds, Ms. Mason-Wood says to watch out for securities that have a senior subordinate structure. Senior debt holders, often banks, will get paid back before the average investor.

It's a relatively new structure, introduced about a decade ago. In the past bondholders would get about 30 cents on the dollar in a default workout, but now, says Ms. Mason-Wood, people shouldn't expect even that. "The banks need 100 cents on the dollar," she says. "So retail investors will get a lot less."

Investors should also consider sticking to higher quality junk bonds. While there are situations where people would buy D-rated bonds - bonds already in default - Mr. Braive sticks to mostly B ratings.

A lot of the B companies he's buying are poised for a rating upgrade, he explains. Then he gets the best of both words - a higher yield and, eventually, an investment grade bond. "If we like the spread and find a company that can become investment grade, we want to buy that business," he says.

To find the right bond Mr. Braive suggests looking at industries and figuring out if it's an essential, and growing sector. Find out if the industry has a lot of foreign competition and if it's restructured in the past five years to make it more viable.

Then look at debt ratios and, more importantly for Mr. Braive, earnings before interest and taxes, depreciation and amortization (EBITDA) over the last 12 months. A low ratio suggests the company may not be able to pay interest on outstanding debt. Mr. Braive likes to see an EBITDA of four or five, but three could be fine as long as their interest coverage is expected to improve over time. "When the coverage gets too skimpy, then that's a red flag," he says.

Buying a high yield exchange-traded fund, like iShare's Canadian dollar hedged U.S. High Yield Bond Index Fund is another way to buy into this market. Mr. Cunningham prefers ETFs because they're well diversified among sectors, ratings and duration. The majority of XHY's 400 bonds are between B- and BBB+, with most of the weighing in stable sectors like consumer staples, financials and telecom.

Plus, if 3 per cent of high yield bonds default, it still leaves 97 per cent of the ETF's holdings paying interest so there's less risk, says Mr. Cunningham.

While Dr. Mossman says he would add high-yield bonds to his portfolio, he doesn't own any directly right now. His balanced mutual funds own some low-rated bonds, he says, and at this point, that's all the junk he needs.

"The real issue is getting adequate diversification at a reasonable cost," he says. "I don't want a large exposure to high yield bonds, so [I'm happy] getting it through a balanced fund."

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