Riddle me this: Why would anyone ever buy junk bonds or a junk bond fund? It’s Andrey Dashkov here, your chief analyst making another guest appearance in this week’s missive.

Now, before I share the answer, note that credit ratings from agencies like Standard & Poor’s, Moody’s, and Fitch do not reveal the whole picture about risk. Bond ratings only deal with one risk: default.

These ratings should help investors discern investment-grade bonds from lower-rated bonds commonly referred to as junk bonds. These agencies rate the bonds and their probability of default. AAA-rated bonds, on average, have a default rate of zero; B-rated bonds, on the other hand, have a historical default rate of 4.3%.

So, why buy junk bonds or a junk bond fund? If there are enough interest-rate differentials to offset the default probability, then junk bonds can be more favorable than the alternatives.

Dennis and I have written a lot of articles about diversification. It’s a complex subject to say the least. With bonds in particular, to really understand diversification one must look behind the curtain.

Let’s look at two of the most common rules of thumb:

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

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

BSCI runs the full gamut of investment-grade ratings (from AAA-rated 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 lower-rated bonds historically have a higher rate of default. Normally, bondholders do not lose all their money in default because they are ranked higher on the creditor totem pole; however, on average they lose about half.

The Second Measurement of Safety: Duration. Average effective duration (a measure of the sensitivity of the price of a fixed-income investment to a change in interest rates) of the BSCI portfolio is 3.9 while it’s only 3.2 for BSJI. Investors should understand that duration is a historical calculation and an estimate. As we hear from television commercials, “individual results may vary.”

Using the duration history as a guide, for every 1% rise in interest rates, the market price of BSCI should drop 3.9%, while BSJI would drop 3.2%—18% less.

The chart indicates that BSCI has shown much more interest-rate sensitivity because investors looking for yield had poured into the fund. In the case of BSCI brokers and money managers, operating on the principle that safety and diversification are key, generally take the more conservative approach to limit their own liability. Bluntly, clients are less likely to bark about the safe approach.

The Third Measure of Safety: Correlation. BSCI and BSJI are both bond funds, but their correlation to 10-year Treasuries paints a much different story. The correlation (a statistical measure of how two securities move in relation to each other) between the 10-year Treasury rate and BSCI is -0.6, which means that when interest rates rose, BSCI’s price dropped at the same time in 60% of cases. One would have to take a loss and sell it in the market or hold it at a much-lower-than current-market interest rate.

One-year correlation between 10-year Treasuries and BSJI is 0.08. This tells us that the correlation between interest rates and BSJI share price is insignificant: when interest rates rose, BSJI rose simultaneously only in 8% of cases.

Within a portfolio, it’s best to hold assets that are correlated as weakly as possible. If some of your investments become too interest-rate sensitive, one-year correlation data suggests that a junk bond fund like BSJI will diffuse the risk better than a fund that has a lot of investment-rated debt in it. That’s counterintuitive, we know, but the data shows that that’s how it worked during the past year. We have to remind you that the correlation coefficient would differ from what we calculated if you look at another time period.

Yield is the primary reason many baby boomers and retirees own bonds, and they generally plan to hold them to maturity. While the duration and correlation numbers are important, if an investor does not have to sell the bonds before maturity and has the strength to stomach day-to-day price swings, he’ll be fine.

Here is the common sense bottom line. Currently BSJI has a yield to maturity of 4.9%, while BSCI has a yield to maturity of 2.2%. So, which looks safer? That depends on what risk one is trying to avoid.

BSCI is diversified among higher-rated corporate bonds and has a lower probability of default. Because of that low risk, it is currently paying 2.2% yield to maturity.

Should the interest rates on treasury bonds rise, one would face two choices: hold the bonds until maturity at a rate currently below the inflation rate (guaranteed loser) or sell them in the aftermarket at a loss.

Why would an investor buy a so-called “safe” bond fund that does not keep up with inflation?

With the Guggenheim High Yield Fund paying 4.9%, should interest rates rise, one would take a smaller loss if he needed to sell before maturity. If one holds on until maturity—even with the possibility of higher default—his yield will be more than double that of the so-called “safe” bond fund.

Here are the key takeaways. What the rating agencies tell you is not the whole picture. The bond rating only deals with one risk: default. The risk of losing buying power to inflation, or having to sell at a significant loss when interest rates are rising, can also pose a substantial risk. Inflation is the silent enemy of your retirement money.

Sometimes a debt instrument or portfolio that looks swell on the surface will underperform its counterpart that’s deemed too risky by conventional wisdom. When it comes to bond portfolios, don’t just look at credit ratings. Duration and correlation will tell you much more about other bond risk factors than letter abbreviations created by institutions whose criteria for safety may be substantially different from yours.

On the Lighter Side

I stepped in for Dennis in this week’s column so he could recover from all the fun he had last week with his grandchildren in Arizona. Apparently no matter how late they stayed up, they wanted to climb into bed with grandma and grandpa at the crack of dawn. He does, however, have critical news to share about our Bulletproof Income Portfolio. Click here to read Dennis’ letter now.

And don’t worry, Dennis sent along some funnies from his friend Tom B.—graphs about life’s many truths: