Shareowner: JUNK BONDS: UNATTRACTIVE AT ANY PRICE

Discouraged by historically low interest rates, an increasing number of fixed income investors are reaching for higher yielding, lower-quality bonds. Some, attracted by seemingly secure double digit returns are even venturing into the speculative, junk-bond market. I think that's a serious mistake.

Junk bonds carry enormous risk. In fact they are really a form of fixed income gambling. Many of the issues default. Without realizing it, these investors are purchasing sub-standard securities in the hope that nothing goes wrong.

What Are Junk Bonds?

There is no hard and fast definition of a junk bond; but, as a rule the term is applied to fixed income issues rated BB (Speculative) or lower by the Dominion Bond Rating Service (DBRS). Essentially that means the issuing company can meet its fundamental commitments for the moment but any adverse business conditions are likely to impair the interest distributions and principal repayment. In other words, there is no margin for error.

To put that into perspective, the Dominion Bond Service gives top corporate credit an AAA rating (indicating substantial strength) while the lowest rating, D means a company is in default. BB lies in the middle of the range.

One thing that you have to keep in mind though is that these ratings are constantly changing. For instance, because of a collapse in newsprint prices DBRS recently downgraded the debt of two major companies Abitibi and Bowater from BBB to BB and consigned their debentures to junk bond status. The fact is, you could end up in the junk-bond market without trying to be there.

Oasis Or Mirage?

The case for junk bonds is that they offer a yield that is supposed to more-than-pay-for all the additional risk involved. Enthusiasts point out that investors have been bidding these issues up in recent months - U.S. junk-bond funds arc looking at 20% returns for 2003. Another alleged 'plus' is that default rates have dropped to 5% this year. Moreover, 95% of American companies with revenues of over $35 million issue debt graded BB or lower. So, by ignoring junk bonds, investors are cutting themselves off from a great slice of the market.

These arguments are unconvincing.

In the first place the record shows that we can expect a 10% default rate as credit tightens, to say nothing of countless other companies that are going to have difficulties.

Second, the 20% returns in New York are due to extraordinary circumstances. It's unlikely that we will see a repeat.

Third, I feel strongly that small Canadian investors should always steer well clear of bonds issued by smaller companies. Forget about this part of the market. It's almost impossible to monitor and you arc likely to lose track of your money.

Finally, and most important, it's a fallacy to believe that junk bonds compensate you for the risk involved.

Let's look at the numbers. You can expect to lose 5% - 10% of your capital and for that sort of risk you should earn returns equivalent to those possible in the speculative stock market where your investment could double. The upside on junk bonds is nothing like that; their risk/return relationship is poor.

Risk/Return Relationship

To put it simply, all investments entail some degree of risk and, as a rule, in orderly markets the potential returns are commensurate with the dangers involved. To give you an example, 30-day treasury bills are extremely safe and consequently yield a paltry 2.75%. Long- term corporate bonds carry more risk so these days they pay about 6.50%. In the stock market top fund managers strive to earn about 10% per annum to compensate for the chance of capital losses.

Turning to junk bonds - speculative securities backed in many cases by companies already in trouble - it is reasonable to expect extraordinarily high yields to compensate for the risk. Yet this isn't the case.

For example, in the United States junk bonds yield about 9.5%, about 500 basis points above 10-year treasury rates. In Canada, the BBs (such as Bowater's debentures) offer an 11% return. While that represents a premium of about 450 basis points over investment-grade corporate bonds, its not nearly enough to make them attractive.

If further proof is needed, just look at the lackluster performance of Canadian high-yield (i.e. junk) bond funds. Trimark Advantage Bond Fund earned an average of 6.0% over the last five years. GGOF Canadian High Yield Fund earned an average of 5.6% during the same period.

Perils Of The Bond Market

In addition to the high credit risks and dangers of default, junk bond investors also have another serious problem. As a rule brokers require a minimum investment of $5,000 and all bonds trade over-the-counter. In other words, the bonds are not bought and sold in a transparent auction-market like the TSX where you can see the bid and asked prices. In most cases, your broker owns the bond you want and sets the price. Conversely, your broker buys the bond when it's time for you to sell and, once again, sets the price.

If you are trading short-term Government of Canada bonds, where there is an active market, it's possible to check those prices by phoning other brokers. Most of the time, however, you have to accept the quotes.

When it comes to dealing with junk bonds this problem of having no transparent market becomes much greater. Many of the junior or lower-quality corporate issues rarely, if ever, trade. Consequently the quotes that your broker provides are just estimates when, in fact, there is no bid. In short, you may find that your junk bonds are illiquid and worth a great deal less than you think.

Keep in mind too that these are fixed income securities, not stocks. People buy them for the interest income and any bids will evaporate if there is the slightest suggestion of a default. For example, a few weeks ago many Canadian BB bonds were yielding in the 10% range. However, because there was concern over Stelco's debentures, they plummeted to $25 per $100 face value and were yielding 52% with no bids. That gives you insight into the volatility and uncertainty of the junk bond market.

Diversification

In fairness, junk bond advocates concede that the risks are high but maintain that this can be reduced through diversification. The idea is that an investor should own an array of high-risk bonds and limit exposure to any one company. That way any losses are limited.

The fact is, however, that typical individual investors have neither the time nor the means to maintain and monitor a diversified junk-bond portfolio. Each junk bond is an individual, perhaps unique, investment that may default. Therefore, in practice it's necessary to track each issuing company just as though you owned the poor-quality common shares. It's an onerous task for the small additional returns you might get.

Alternatives

My own view is that you should never knowingly buy high-risk investments - bonds, stocks, anything. It's not worth the trouble and stress.

Instead build a portfolio of Great Stocks for capital appreciation and supplement it with government bonds on the income side. That way you can earn above average returns and sleep at night.

TOM SLEE, CGA, CFA IS AN AUTHOR, MONEY MANAGER, AND TAX EXPERT SPECIALIZING IN CONSERVATIVE INVESTING