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Why I have added a few high yield bonds recently?

Updated on March 30, 2012

A few days ago a WSJ writer asked me about investing in high yield. You know he must be a good thinker and writer because the question alone made me think about sharing with my ordinary investor friends lessons on that subject.

You can read Mr. Wirz article in the Friday, March 30, 2012 issue of the Wall Street Journal.

My reasons for adding a few high yield bonds now are (1) income (2) capital gain opportunity and (3) diversification.

INCOME

We income investors are starved for income and are much too heavily exposed to equities since we cannot get yield from safe bonds. You have to have a ton of money to live off of 1 or 2 percent. We have been squeaking by on the 3-6 percent in dividends with the more savvy income investor using covered calls to boost income up to 8-10 percent.

My goal on a high yield bond is a yield of about 7%. Junk bonds that yield more than seven percent, I have found, are way too risky. Yet a seven percent yield can be had. For instance I just sold a Ford bond with a coupon of 6.375%. I bought this bond for $83.35 per bond. At that purchase price, my yield was north of 7.5%. Ford was the only U.S. car company that did not take the government payout.

CAPITAL GAIN

In addition to income, we have a chance for capital gains if we carefully select high yield bonds and always buy at a discount or at least no greater than par. Carefully selected high yield bonds have worked quite nicely and I can mitigate my risk from interest rates rising by laddering the bond maturities.

The Ford bond illustrates how this works. While the Ford bond (a 2029 maturity) would have paid me back $100 when it matures in 2029, I am almost sure that interest rates will go up significantly in the next 17 years. Holding the bond to maturity is my downside position. I know that as interest rates go up the value of a bond goes in the opposite direction which is down. No matter how much the value of the bond changes, I will still get back $100 per bond upon maturity assuming Ford does not go out of business or default on its debt.

But the real opportunity with this Ford bond is that the price improved. You cannot be too quick to trade and like all investing you have to keep in touch with the price. When I noticed the price of this Ford bond on my online statement was $108, I wanted to sell but Schwab (my broker) could find a buyer willing to pay me only $105. Bond pricing is very different from stock pricing and I decided to wait. Two weeks later, I called the bond desk again and they found a buyer at $110. So you see not only can high yield bonds deliver higher yield, you can also get capital gain.

DIVERSIFICATION

High yield bond investing also provides diversification and diversification is one of the most important aspects of a successful investment strategy. Notice that we income investors are living with the inherent risk of the stock market, it is not such a stretch to spread our diversification into bonds. And, we move up the capital structure. By that I mean if something goes wrong at the company, we get paid before the stock holders.

This was the case until the government intervened in General Motors. In all my investing years, until the 2008 crisis, I never had a bond default. I have experienced a few scary restructures but never a full default. I cannot let one experience sour me forever on investing in bonds.

So if we are going to take on additional risk, why not try a few high yield bonds to boost our income. At least for every day we hold the bond, we receive income, unlike dividends.

My most recent fling is a very risky bond issued by Arch Coal. Arch Coal is a company whose stock is really suffering because the country wants more clean energy and because it costs less to use gas to create the same energy created by coal. But it is a decent company so I am taking risk and buying the 2012 7.25% junk bond, the CUSIP is 039380AC4.

Use the Sifma site, investinginbonds.com to find bonds, then research the issuing company, finally call your broker to find out the details and see if it fits into your income investing strategy.

But please, do not invest in bond funds. That is a hub for another day.

Very Truly Yours,

TheMoneyMadam


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