The Safest Way to Invest in "Junk" Bonds

"Junk Bonds? Didn't those risky things go the way of the DeLorean, Gordon Gecko and Michael Milken back in the 1980s?"

That snarky question was recently asked my trading partner during a recent conversation about long-term investments.

It's true that junk bonds are considered riskier investments, primarily because they have a higher default risk than "investment-grade" bonds or U.S. Treasuries. But as I'll explain in a moment, higher-yielding so-called "junk bonds" have rarely been safer as an investment. 

"Junk" is now "safe" Although very popular in the 1980s, investors may recall stories about the fall of junk bond king Michael Milken and Drexel Burnham Lambert and be turned off to the notion of investing in junk bonds. That would be a mistake. In fact, junk bonds are even more popular today -- although somewhat under the media's radar. 

The difference in the 1980s was that money-management firms such as Milken's used junk bonds to finance hostile takeovers. Today, junk bonds have rarely been safer: the global junk-bond default rate was only 3% in September, according to ratings service Moody's. 

Put simply, companies are taking advantage of historic low interest rates to refinance their debt, lower borrowing costs and extend their credit lines, thereby reducing the risk of default. There have been $184 billion in new junk-bond issuances so far this year, compared with 2010's all-time record of $264 billion in new issues. If things keep rolling, 2012 may just take the lead as the biggest year ever for junk bonds.

Investors are flocking to junk bonds in droves, leading the average yield to plummet to an all-time low of roughly 6.5%, down from a historical average of more than 10.

Despite these lower yields, I still think junk bonds are a good investment right now. One reason is because, hey, a 6.5% average yield is still nothing to sneeze at. The other is because today, investors have one simple tool that gives instant diversification and lowers exposure to losses stemming from default: exchange-traded funds (ETFs).

Two of the largest in the junk-bond universe are the iShares iBoxx High Yield Corporate Bond Fund (NYSE: HYG) and SPDR Barclays Capital High Yield Bond Fund (NYSE: JNK). 

These ETFs have not only opened up the junk-bond world to everyday investors, but they have changed the high-yield environment. Because of the ease and low comparative costs of these ETFs in relation to individual bonds, they're becoming more popular.

In fact, the popularity of junk-bond ETFs has reached such a level that six new funds have debuted this year, including global and emerging-market funds.

The best choice of junk Clearly, when in comes to investing in junk bonds, investors have a wide array of choices today. But which ETF is the best in terms of safety, diversity and valuation? My bias is toward the fastest-growing junk bond ETFs, not the largest ones such as JNK. In this regard, I like the Power Shares Senior Loan Portfolio (NYSE: BKLN). Its assets under management (AUM) have surged more than 50% since July. This rapid increase in AUM clearly indicates that this ETF has gained the interest of institutions as well as the investing public. 

Aside from its nearly 5% yield, I also like this ETF because of its sneaky name. It's not obvious that 84% of its holdings are considered "high-risk" bonds, though its assets are senior notes, which are less sensitive to rising interest rates since they take priority over newer loans. In addition, nearly all of its holdings have maturities of 1-5 years, or 5-10 years. 

Shares have been in a steady uptrend since June 1 and are presently building a base in the $25 range. It's trading up almost 9% year-to-date, and boasts a nice 5% yield. 

The name "junk bond" should be enough to conjure up risky thoughts to most investors. However, these ETFs are diversified among various non-investment grade bonds, although risk remains. The record-low yields allow little room for additional price appreciation of the underlying bonds, and slowing business conditions could make the issuing companies struggle.

In addition, although the Federal Reserve has promised low interest rates through 2014, a "black-swan" event could instantly change this expectation, resulting in dramatically less demand for junk bonds and their corresponding ETFs.