Wednesday, May 7, 2008

Junk Bonds or CD's for a Widow with Children

More regarding the relative advantages of CD's and bonds for the middle class investor:

Today I came across a response by Gail MarksJarvis to a reader who went for high yield and had second thoughts after the bonds were purchased:
Q: I am worried about holding on to bonds issued by Bear Stearns just weeks before the bailout. Although I bought them for $75,000, my broker told me a few weeks ago they were worth only $68,000. I need all the income I can get because I'm a widowed parent with children's college expenses. I'm wondering if JPMorgan Chase & Co. will honor the maturity if the takeover goes through. The bonds, at 5.3 percent, mature in March 2010. I cannot afford to lose that corporate bond money! -- S.V.
A: JPMorgan has said it will assume Bear Stearns' obligations once the acquisition is complete. And because the deal was negotiated and blessed by the Federal Reserve, it's likely to be finalized. When that happens, it will be as though you purchased JPMorgan bonds, not Bear Stearns bonds.

That should give you comfort. Although no corporate bond is as safe as a U.S. Treasury bond or an FDIC-insured bank CD, your bonds will be significantly safer than they were. Instead of a bond in a company teetering on the verge of bankruptcy, you will have a bond backed by one of the nation's strongest financial institutions--one with a Moody's rating of Aaa3 for bonds similar to yours. That's a strong rating.

Of course, investors lately have come to realize that strong ratings aren't always dependable. After all, Standard & Poor's was rating Bear Stearns bonds AA when the company was on the verge of bankruptcy in March. But typically ratings of A and above are a better sign than if you see B's or C's in bond ratings. If you see corporate bonds rated below A, you should assume there is a fairly strong risk that the company could have trouble paying you what you expect.

For a simple-to-read list of bond ratings see: "What Do Bond Ratings Mean?" at www.aarp.org/money/financial_planning/sessionsix/bonds.html.

Learning about risks in bonds is critical if you want to safeguard your money. Although the rescue of Bear Stearns has made your existing bonds more secure, you should make sure you don't take chances again. If you truly cannot afford to lose money, avoid corporate bonds and stick with safer choices...
Two pages down in the same business section was an ad for a CD which paid 4.50% for a 36 month term, no risk to principal at all. To make an extra $600 a year on each bond, the widow was risking a principal loss of $7000.

Frugal Ben says: Ms. MarksJarvis gave S.V. some good advice in the column, but she neglected to warn her about about getting bad advice from brokers. If S.V. took it upon herself to buy junk and ignored warnings from her broker, she got what she deserved. On the other hand, if she was faithfully following the advice of someone she trusted, she needs to be told to get a new broker: Advising someone in her circumstances to pursue higher yield in junk is unconscionable.

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