How To Find Junk Bonds That Don’t Stink [Claymore Exchange-Traded Fund Trust, Claymore Exchange-Traded Fund Trust]

GuggenheimAndrey Dashkov, Research Analyst:  Riddle me this: Why would anyone ever buy junk bonds or a junk bond fund? Before we get to the answer, I would like to point something out that seems to be a given, but that astonishingly few investors think about: bonds are debt instruments, so investing in bonds means investing in debt, governmental or corporate.

Note that credit ratings from agencies like Standard & Poor’s, Moody’s, and Fitch do not reveal the whole picture about the risk these bonds represent. Bond ratings only deal with one risk: default. They are supposed to help investors discern investment-grade bonds from the lower-rated junk bonds. AAA-rated bonds, on average, have a historical default rate of zero; B-rated bonds, on the other hand, have a default rate of 4.3%.

With so many negatives, why buy these debt instruments? The reason that junk bonds are so popular with investors is that if there are enough interest-rate differentials to offset the default risk, junk bonds can be a better deal than their triple-A peers and make for a diversified bond portfolio.

Diversification is a complex subject. With bonds in particular, to really understand diversification, one must look behind the curtain.

There are two rules of thumb when it comes to bonds:

  • When interest rates rise, bond prices fall. This is true for fixed-rate debt, and it works most of the time.
  • Investment-grade bonds are good while speculative-grade bonds are just that and have a much higher risk of default.

The Guggenheim Battle

Let me illustrate my point with two Guggenheim funds: Guggenheim BulletShares® 2018 Corporate Bond ETF (NYSEARCA:BSCI) and Guggenheim BulletShares® 2018 High Yield Corporate Bond ETF (NYSEARCA:BSJI). Both are target-maturity funds expiring in 2018.

BSCI runs the full gamut of investment-grade ratings (from AAA down to BB-) and currently pays 2.2% yield to maturity. On the surface, it is well diversified and should be safer because of the investment-grade ratings.

The BSJI portfolio is diversified among lower-rated bonds and pays 4.9% yield to maturity. The junk bonds historically have a higher rate of default. In a default, normally bondholders don’t lose all their money, because they’re higher up on the creditor ladder; however, on average they lose about half.

Safety‘s in the Duration

Average effective duration is a measure of the sensitivity of the price of a fixed-income investment to a change in interest rates. For the BSCI portfolio, it’s 3.9; for BSJI it’s only 3.2. You need to understand that duration is a historical calculation and an estimate. As the TV commercials say, “Individual results may vary.”

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