Some Junk Bonds Look Safer Than Stocks

To review, a high-yield bond by definition is any corporate bond that has a rating of BB or lower. BBB and A or higher are investment-grade ratings. High-yield bonds are also known as junk bonds because of their higher default rates.

As noted in an article on preferred stocks, there is a hierarchy in case of a bankruptcy: bank debt, senior debt, junior debt, accounts payable, preferred stock and then common stock. In bankruptcy court, usually the senior debt holders and junior debt holders fight over the value of assets.

Let's pretend that a company goes into bankruptcy, and its main asset is a factory that's worth about $300 million. Let's also assume that the face value of the senior bonds is $400 million and the junior bonds are $200 million. The senior bond holders will hope the judge determines that the factory is worth as low a price as possible. This way, they will get more of the factory and may be able to exclude the junior debt. The junior bond holders hope that the factory gets as high a valuation as possible. This way, they will get more for their bonds. After court, the bonds are converted into stock. Then, these classes become equity holders. So you can see why junk bonds yield more than safer bonds.

The problem with junk bonds for individual investors is that size matters. Most junk issues must be bought in large blocks -- often times $1 million. Trades are illiquid, too. It's much easier to buy a fund than to trade individual high-yield bonds.

The Vanguard High Yield Fund (VWEHX) is an excellent place to start. Its fees are only a paltry 0.25%, and its yield is 10.17%. Over the past year, it dropped 16.19% in value. That's pretty good compared with the S&P 500, which dropped 38% over the same time frame. That's a 22% outperformance. Who says that junk bonds are risky? They are -- just not as risky as stocks.

The fund has some familiar names: Ford(F Quote - Cramer on F - Stock Picks), Freeport-McMoRan(FCX Quote - Cramer on FCX - Stock Picks) and Coventry Health(CVH Quote -Cramer on CVH - Stock Picks). Sure, these are risky, but less risky than the underlying stocks.

What are risky are financial junk bonds. Investment banks are levered to their eyeballs, and who knows what their assets are? Freeport-McMoRan has $42 billion in assets and $13.5 billion in tangible equity. That's a ratio of 3.23. What is scary is Citigroup(C Quote - Cramer on C - Stock Picks), which has $2 trillion in assets and $63 billion in tangible equity (according to Yahoo! Finance). That's a ratio of 32.5! With Freeport, at least you know that if it goes bankrupt, you have a claim on its copper and gold mines. With Citigroup, you get a claim on a portfolio of credit card receivables. Yuck!

iShares has a high-yield ETF, the iShares iBoxx High-Yield Corporate(HYG Quote - Cramer on HYG -Stock Picks). Its expense ratio is a little higher at 0.5%, and it has a yield of 11.18% (according to Yahoo! Finance). Like the Vanguard fund, this ETF holds many non-financial junk bonds, including Dollar General(DG Quote - Cramer on DG - Stock Picks), Constellation Brands(STZ Quote - Cramer on STZ - Stock Picks)and Peabody Energy(BTU Quote - Cramer on BTU -Stock Picks).

Is now the time to buy these funds, or is it too early? Tough call. There is basically a 7% spread between the yield on these funds and the comparable Treasuries. But if the Treasuries rise in yield, that gap will close. Also, if many of these bonds drop in value, it will kill the funds' net asset value.

There is definitely risk. However, one can say that the bonds will be a lot less volatile than the common stocks of the likes of General Electric(GE Quote - Cramer on GE - Stock Picks) and Bank of America(BAC Quote -Cramer on BAC - Stock Picks). Whether you think it's too early or that now is the time, these funds offer a great way to make a profit in these crazy markets.