U.S. Markets closed

Should You Buy into the Junk Bond Craze?

Ron DeLegge

Since the beginning of time, the investing masses have always had a self-destructive streak in them. And this time around, it's more of the same.  

Since the beginning of the year, retail investors have sunk almost $12 billion into junk bond mutual funds, according to Lipper. That amount easily outpaces the $4.8 billion plowed into stock mutual funds (Nasdaq: VFINX - News) thus far.

'Junk' bonds are high risk debt issued by corporations with a spotty credit score. According to rating standards from the Three Musketeers - Moody's (NYSE: MCO - News), S&P (NYSE: MHP - News), and Fitch -  junk bonds generally have a rating range from Ba1/BB+/BB+ or below.  In other words, it's almost like lending money to your cousin Vinny who never pays on time, except when Vinny misses a payment, you can put a brick through his window because you know where he lives.

Piling In The next question is this: Who in their right mind would want to lend money to a bunch of corporate nincompoops who don't pay their bills on time?

An article titled, 'Buyers take a Shine to Junk'' from the Wall Street Journal explained in part, 'neither U.S. Treasury bonds (NYSEArca: TLT - News) nor investment grade bonds (NYSEArca: AGG - News) are expected to deliver meaningful returns this year.'

The 12-month yield on junk bond ETFs like the SPDR Barclays Capital High Yield Bond ETF (NYSEArca: JNK - News) and iShares iBoxx $ High Yield Corporate Bond Index Fund (NYSEArca: HYG - News) hover between 7.25 to 7.35 percent compared to 2.81 percent for higher rated corporate bonds (NYSEArca: AGG - News).

Translation: People are chasing higher yields from 'junk' bonds, because they're not getting enough income from investment grade corporate bonds, dividend paying stocks (NYSEArca: SDY - News), money market funds (Nasdaq: VMMXX - News), or U.S. Treasuries (NYSEArca: IEF - News). And as result, they are taking on more financial risk.

Testing Your Risk Aptitude Are you a yield hog? Before you answer that question, I've assembled an impromptu exam to help you find out. Answer 'yes' or 'no' to the below questions:

1) I've dumped my all or part of my investment grade bonds and U.S. Treasuries in favor of 'junk' bond funds.

2) I regularly scan for stocks, mutual funds and ETFs with the highest yield.

3) I buy stocks, mutual funds, and ETFs with the highest yield - without considering risk factors and other important details.

4) I'm more excited by the yield of an investment, than its risk profile or its historical performance return.

If you answered 'yes' to just one or multiple questions listed above, then I would classify you as 'yield hog.' (I chose the word 'hog' because it sounds nicer than 'pig.') 

Lower Risk Income Alternatives

Imitating the crowd's investing preferences may result in a temporary high, but the long-term results are usually ugly. And if the crowd wants to eke out a few points of additional yield in exchange for taking massive risks with their principal, go ahead and let them. Be fearful when others are greedy.

Rather than following the crowd, look at alternative income strategies that reduce your financial risk - not increase them.

At ETFguide, we assembled a hypothetical $100,000 all-ETF portfolio and our March Income Trade generated just over $1,300 in monthly income. Instead of chasing yields, we use a simple but time-tested strategy that institutional investors have been quietly using for decades.

Here's another nugget: The annual cost of our all-ETF portfolio is roughly 80% less compared to traditional mutual funds in the same exact investment categories. And even a dumb yield hog should be smart enough to know, a substantial decrease in investment expenses translates into a wonderful increase in yield income.

More From ETFguide.com