The One Risk You Need to Avoid

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Halloween is one of my son’s favorite times of year, right after his birthday and Christmas of course. He loves going trick-or-treating, but the part he likes most is actually going to pick out a costume.

In fact, we go to the Halloween store almost once a week, so he can play with all the spooky attractions and check out the scary costumes.

But no matter how many times he goes, the giant spider near the front of the store always jumps out at him and has him on edge the rest of the visit. It scares him even when he knows it’s there. But it’s a risk that he’s willing to take because the reward outweighs the scare at the start of the visit.

Right now, the market is like a trip to the Halloween store, but the fright that’s waiting for investors might outweigh any potential rewards…

Investing should be fun and extremely beneficial, and most times that is the case. But every so often, a market crash comes along and terrifies investors once again. It’s like the spider that jumps out at you when you walk into the Halloween store. Even though we know an inevitable reversion to the mean is just ahead, it still scares us when it actually happens.

This reversion to the mean is rarely inclusive of all investments. In fact, it’s usually just a few at a time. There is one investment today, however, that is set to terrify investors — junk bonds.

Weaker Economic Growth Spells Trouble for Junk

A junk-rated bond carries a significant amount of default investing risk, meaning it has a higher possibility not to repay the bonds fully.

Historically, these types of bonds have offered solid yield for the risk you are taking. But thanks to the Federal Reserve’s zero-interest-rate policy, junk bonds are paying out only about 5% to 7%, compared to 7% to 10% before the housing collapse.

That’s a big problem.

Collecting less yield means you are putting more hope into these bonds being repaid in full, but you are also exposing yourself to risk if rates rise — since yields and price are inversely related, as rates rise, prices will fall and your junk bond will suddenly be worth a whole lot less.

Prior to the housing collapse, the market was firing on all cylinders, growing GDP at a steady clip above 3%. Today, third-quarter GDP came in at 1.5% — a pretty abysmal growth rate. If the overall economy is slowing down, how good is the survival rate of a company offering junk bonds?

In an economy that’s producing a GDP of 1.5%, we would normally be demanding even higher yields to take on such risk with junk debt — 5% to 7% doesn’t come close for me. Honestly, I would need double-digit yields in the current market.

As for rising rates being a risk to junk bonds, you know I’m in the camp that believes rates will remain lower for longer than anyone expects, and your need for yield will remain for at least another decade.

But junk bonds are still not the answer.

Not Worth the Risk

But if rates are going to remain low, then why not grab decent yield from these junk-rated bonds? Apparently, many investors are using this logic and pouring into junk bonds.

In fact, during the first three weeks of October, more than $4 billion flowed into junk bond exchange-traded funds (ETFs). This would set the highest monthly inflow ever — as long as it holds up the rest of the month.

Even a 7% yield doesn’t account for the type of risk you are taking as I just mentioned. That’s why even if the target rate at the Federal Reserve fails to lift off anytime soon, market risk (created by both a reversion to the mean and the overall slowdown in growth) alone could be enough to drive rates higher for junk bonds, which means investors that are jumping in today would be sitting on a decent loss.

This Halloween, Stay Away From the Junk

This is one spooky investment that should be avoided.

Aside from the risks you are taking by attempting to generate just 5% to 7% of yield, there are also better opportunities out there; you just have to know where to look.

I wrote an article last week about how to find strong dividend-paying stocks. In that article, we were looking for roughly a 4% yield from a stable blue-chip stock, not a company that is on the brink of bankruptcy like most of the junk-rated bonds.

But you can also look overseas for solid yields.

In places such as Australia and Singapore, many blue-chip stocks generate yields of 7%, 8% or even more — we own several of these inside Sovereign Investor.

So don’t fall for the junk this Halloween. Do some research and find a much safer yield.

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Chad Shoop
Editor, Pure Income