Avoid the Junk Bond Bubble - Do This Instead

Written by Jason Simpkins
Posted April 17, 2015 at 6:37PM

There's something big going on in the junk bond market right now.

You might be aware of it — or heck, even participating.

It's a bubble.

See, with interest rates so low, investors have been on a desperate search for high-yielding investments these past few years.

That's led them to junk bonds, which pay about 6%, compared to 1.9% for 10-year Treasuries.

Junk bonds aren't a bad idea, per se. To the contrary, they've been exceptionally profitable.

Since 2009, junk bonds have returned nearly 180%, or roughly 18% annually, outperforming even this historic bull market.

Problem is, good times like these don't last forever. And this junk bond party is on the verge of being crashed.

The Junk Bond Bubble

At the end of the day, the junk bond bubble isn't any different than the stock bubble, housing bubble, or oil bubble.

The driving force behind it has been the Federal Reserve.

I'll put it this way: It's pretty hard for a company to default when the Fed's giving money away for free.

See, what makes junk bonds junk is that the companies behind the debt aren't especially sound. They run a higher risk of defaulting, and thus pay a higher yield.

That's how debt works.

But with the Fed distorting the market, many of these companies, which would have otherwise gone under, are still in business.

Basically, the Federal Reserve is subsidizing losers and preventing defaults.

Problem is, it's getting harder and harder to stay solvent these days.

Oil prices have fallen substantially, putting many indebted energy companies at risk.

The dollar is strengthening, hurting commodities producers and exporters.

And if the Fed follows through on its promise to raise rates, it will make borrowing more expensive — perhaps too expensive for some.

As Standard & Poor's recently warned:

“We believe that the pending rise in interest rates and borrowing costs, coupled with volatile commodity prices, a protracted strong dollar and a weak euro will likely lead to negative rating actions for some U.S. corporate borrowers, especially speculative-grade issuers, by the end of this year.”

A “negative rating action” translates roughly to “downgrades and defaults.”

Indeed, S&P expects its trailing 12-month junk bond default rate to rise from 1.8% to 2.5% by the end of the year.

And if energy prices remain muted, the number of defaults in the oil and gas industry could be especially high.

The ratings agency keeps a list of “weakest link” companies — those rated B- or worse and with negative outlooks. Seven of the 13 companies added to that list in March were energy companies, which now account for 13% of the total.

Energy isn't the only beleaguered industry, either.

The Affordable Care Act (aka ObamaCare) has rapidly increased demand for health care bonds. In fact, there's been so much investment in health care debt, that these bonds now have the lowest yield of any sector — 4.7%.

So while I understand the market's desire for yield, the junk bond market probably isn't the best place to turn right now.

What should you do instead?

Simple: Invest in dividends.

Reliable Returns

While the outlook for junk bonds is suspect at best, the outlook for dividends has never been better.

S&P 500 companies paid a record-high $94 billion in dividends in the first quarter, up 14% from last year.

In fact, it was the fourth straight quarter S&P 500 dividends hit an all-time high.

No doubt, dividends have been the most reliable option for income investors over the past century.

Since 1930, dividends have accounted for 42% of the stock market's total return. And often, they've done better than that.

In decades such as the 1930s and 2000s, the stock market delivered a negative return, while dividend payouts stayed in the green.

Dividends returned 5.7% in the 1930s, as the S&P 500 shed 5.3%. In the 2000s dividends returned 1.8%, compared to a 2.7% loss for the broader market.

The so-called “Dividend Aristocrats” have proven especially trustworthy.

These are companies that have raised their payouts in each of the past 25 years at least.

Some have even more impressive track records.

Exxon Mobil (NYSE: XOM), for instance, has increased its payout in each of the past 32 years. It currently pays more money in dividends than any other company on the market — $11.6 billion a year.

Rain or shine, bull market or bear, these companies raise their payouts. And that makes them pretty much unstoppable.

In the last decade alone, the Dividend Aristocrats have returned an outrageous 183% — almost double the return of the S&P 500.

So if you're hungry for high-yielding investments, that's where you want to be. Steer clear of junk bonds and load up on these heavy-hitting dividend payers.

Get paid,

Jason Simpkins Signature

Jason Simpkins

follow basic@OCSimpkins on Twitter

Jason Simpkins is a seven-year veteran of the financial publishing industry, where he's served as a reporter, analyst, investment strategist and prognosticator. He's written more than 1,000 articles pertaining to personal finance and macroeconomics. Simpkins also served as the chief investment analyst for a trading service that focused exclusively on high-flying energy stocks. For more on Jason, check out his editor's page. 

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