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I would like to start investing in junk bonds, but I have only $500 to $1,000 to invest for now. I don't want to buy a bond fund; I want to buy an individual bond. What do you recommend I do?
-- Brandon, Birmingham, Alabama
I can't think of a worse way for you to invest $1,000 than to buy a single junk bond (or "high yield" bond as this type of bond is euphemistically referred to).
All right, maybe that's a bit of an overstatement, but not by much. There are so many things wrong with your plan, I scarcely know where to begin.
A very costly approach to investing
So let's start with costs. When you buy an individual bond through a broker, that broker either takes it from his firm's inventory of bonds or buys the bond from a bond dealer and then resells it to you.
Either way, you pay a mark-up, essentially the difference between what your broker paid for the bond (or the price your broker's firm set on the bond in inventory) and the price your broker charges you for the bond.
You may or may not also pay a commission, but the main cost is in this mark-up. The mark-up can be quite small, well under 1 percent, if you are dealing in highly liquid bonds, such as Treasuries, and dealing in large amounts, such as $1 million or more.
If you are dealing in less liquid bonds -- and junk bonds definitely qualify as less liquid -- the mark-up is higher. The mark-up is also higher when you are dealing in small amounts -- and $1,000 is not small, it is as tiny as tiny can be in the bond market.
Combine the lower level of liquidity with the tiny amount you're investing, and I wouldn't be surprised if you paid a mark-up in excess of 5 percent, and possibly much, much more.
They are called "junk" bonds
Let's move on to credit quality. They're not called junk bonds for nothing. Junk bonds are issued by companies that have limited resources to pay the interest on their bonds and to repay the principal. As a result, junk bond issuers tend to default at much higher rates than issuers of, say, investment-grade munis or corporate bonds.
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A Standard & Poor's study of default rates I saw a couple of years back showed that 23 percent of junk bonds had defaulted within 15 years of being issued, or about ten times the rate of default in munis.
Of course, that's an average for all junk bonds. The default rates of the lowest rated junk bonds -- the bottom of the junk pile -- are even higher. (To check out the rating scale which classifies bonds as either investment grade or non-investment grade (or junk), check out the bond rating sections of the Standard & Poor's and Moody's Web sites.
What about diversity?
Finally, let's talk about diversity -- or, in your case, lack of it. You intend to buy a bond. One bond. That means you are linking the security and the return of your one thousand bucks on the fortunes of just one company. That's never a good idea, and it's an even worse idea when bond rating agencies already know that the company's financial condition is tenuous.
In other words, junk bonds are the type of asset that cries out for more diversification, not less. So far from buying one bond, you should be thinking of buying dozens of junk bonds to diversify away the risk that your investment will suffer because of problems with one company.
All of which is to say that buying a single junk bond isn't investing, it's speculating. If you want to own junk bonds, a junk bond fund is the only way to go. But I'll go even further. I wouldn't even recommend a junk bond fund unless you already own a bond fund that holds investment-grade corporates and/or government bonds. And even then I think the junk fund should represent a relatively small portion of your bond stash.
If you really, really insist on going through with what I consider this foolhardy notion of buying individual bonds, you can check out sites such as TradeBonds.com and BondVillage.
A growing number of discount brokers also offer bonds online. I'm not sure how large a supply of junk bonds you'll find online, and I'm not even sure you'll be able to buy just one bond for $1,000.
But if you want to go about this the right way, I suggest you think in terms of building a diversified bond portfolio through mutual funds, in which case you can begin your search for decent bond funds at our Fund Screener.
Good luck either way, although I think you'll need that luck a lot more if you buy just one bond.
Walter Updegrave is a senior editor at MONEY Magazine and is the author of "Investing for the Financially Challenged." He can be seen regularly Monday mornings at 7:40 am on CNNfn.
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