You know you shouldn’t. Your CPA wouldn’t approve. Your wife would be furious if she found out. The guilt would consume you. Still, you can’t help casting a lustful glance at junk bonds with their 10-12% coupons. Just remember flashy investments usually go up in smoke, and when these babies fall, they fall hard. They’re called “junk” for a reason.
Lately, I’ve received a lot of emails about junk bonds and how (if) to invest in them. Here’s a short and to-the-point lesson in what they are and whether you should add them to your portfolio.

The Fundamentals of Junk Bonds

Bond rating agencies such as Fitch, Standard and Poors, and Moody’s assign ratings to debt issues. So-called investment grade bonds have a rating of BBB or higher. By assigning such a rating, the agency is saying that it believes, based on the company’s current financial position, interest coverage ratio, and economic outlook, that the chance is default is not substantial. These issues often have a history of long, uninterrupted interest payments to bondholders.

Non-investment grade issues, on the other hand, are those that have been assigned a rating of BB or lower. These obligations possess a much higher risk for default or loss of principal. The companies that issue these “junk” bonds must somehow entice investors to risk their money. In order to do this, they offer a much higher coupon rate (e.g., 10%) than their investment
counterparts (e.g., 5 1/2%). Ironically, this increases the inherent risk because the companies that are least able to afford high interest charges pay double or triple their better-capitalized counterparts. Every bond in the world falls into one of two categories… investment and non-investment grade. There is a huge of difference between the two. Investment grade usually have a rating of BBB or higher. It is a safe bet to assume that they posses solid fundamentals, a stable balance sheet, and are not in serious risk of default or bankruptcy. Most have a long track record of making steady interest payments to their bondholders.

Junk bonds were tremendously popular in the generation of leveraged buyouts and corporate liquidations (otherwise known as the 1980′s). Lately, they have staged a slight comeback with a potentially disastrous outcome. Small investors are buying them without fully understanding the risks they carry (and once they do figure it out, it will already be too late.)

Fallen Angels vs. Junk Bonds

In the course of business history, good companies have sometime experienced troubles that caused their debt ratings to be slashed. The company’s bond issues plummet as a result. These type of issues are known as “fallen angels”. They differ from junk bonds in that they were issued as investment grade and fell from grace. Purchasing fallen angels, if done intelligently, is far less speculative than acquiring junk bonds with the hope of holding them until maturity. This type of operation should be left to those who are able to evaluate a corporation’s financials and reasonably estimate the potential outcome of the situation.
The Bottom Line on Junk Bonds
Avoid them like the plague unless you know what you are doing. If you do purchase them, do so with full understanding that unless you have substantial quantitative reasons to believe your purchase promises a safety of principal, you are speculating, not investing.

Investing Non-Cash Producing Assets

As you learnt in the Time Value of Money articles, the intrinsic value of any asset is all of the free, unrestricted future cash that it will generate discounted back to the present at an

appropriate rate. What about assets that don’t generate any cash, such as bottles of wine or fine art? In this case, you must consider the total net price you think you can command at the time of the sale. You must then calculate your Compound Annual Growth Rate based upon how long it takes you to sell. If the figure is substantially more than you expect to make from any of your other investments, it may be worth considering as long as it is within your circle of competence (more on that later).

The danger is that collectibles are subject, to a large degree, to the individual tastes and preferences of the populace at the time. What makes a Rembrandt or a Picasso worth $20 million, $50 million, or $100 million? Simply the fact that others will pay such prices. Unlike a car wash or chain of burger restaurants, there is no underlying cash stream upon which the value is based. With the latter type of investment, it doesn’t matter if the real estate market crashes – you can still rely upon the customers who are generating cash for you. There’s also the issue of theft; you can’t exactly throw a building into the back of a pickup truck and make a break for it like you can with a case of valuable wine.

For that reason, you may want to insist upon an additional margin of safety. A rare book set that you follow, normally trading at $2,000, may be compelling at $1,800. If you come across it for $900, however, you have left yourself ample room for attractive investment returns even if the item were to suffer a substantial shrinkage in value. Such opportunities are ephemeral, yet they do occur from time to time.

Your Circle of Competence

Long-time readers of the site know that I am a big fan of Warren Buffett’s concept of the “circle of competence”. The basic crux of the philosophy is that you never stray beyond your level of understanding when allocating capital. A person who works in the oil industry probably understands exploration and the economics of refining. A person who works in entertainment can probably have an intelligent idea of the direction of content delivery in the next ten years and how it will affect the major networks and media conglomerates. Both individuals have clear circles of competence; if they focus their investments on those areas they understand, they are likely to do better than if they blindly accepted a portfolio of stocks recommended by a high pressure broker. On Wall Street, there is a well-told story about a man who became so familiar with the economics of the American Water Works Company that he knew the cost and profit every time a toilette flushed. He spent his entire life buying and selling this one, single stock and died a multi-millionaire.

Obviously, it is not a wise policy to hold your entire net worth in a single stock. The idea of focusing your attention on areas that you are likely to have an advantage over the competition, however, is likely to serve you well. If you are a molecular biologist, you are probably going to have a much easier time evaluating than research and development pipeline at a major pharmaceutical company than you are estimating the excavation costs for gold mining stocks.

Your asset allocation should reflect that – including in the area of rare collectibles.
A few tips to remember:

1. Do your homework well before you are confronted with the opportunity to buy.
2. Be honest with yourself about where your circle of competence ends. Flattering yourself by imaging your expertise to be larger than it really is exposes you to the risk of overpayment.
3. Don’t allow yourself to be afraid of missing an opportunity. Far better to miss riches than ruin yourself.
4. Cynicism can be a very profitable trait in investing. Always ask yourself, “What Could Go Wrong?” before making any investment.