‘Junk Bond’ Risk Cut With Diversification

QUESTION: I have recently been approached by a broker to invest in some high-interest bonds paying in the neighborhood of 15%. The broker claims that they are very safe because they are from well-known, national companies. If they aren’t risky, why do they pay such a high interest rate?--S. P.

ANSWER: If there is one immutable law of investing, it is this: All other things being equal, interest rates--on bonds or any other investment--vary according to the risk of that investment. So, let’s examine the risk of the bonds your broker is suggesting.

These issues are officially known as “high-yield” bonds, but perhaps you know them better by their Wall Street slang: “junk bonds.” They were dubbed junk because the current business conditions and future prospects of the companies issuing them were viewed as so uncertain that the official debt rating agencies, Standard & Poor’s and Moody’s, rated the bonds below “investment grade.” (S&P; defines junk as anything with a rating of BB or below, while Moody’s cutoff is Ba.)

In general, these ratings offer an opinion of the issuer’s likelihood of defaulting on repayment of the bonds. However, a junk rating does not imply any certainty that a default is imminent or even highly likely. The rating means only that, compared to other issuers, one particular company faces greater obstacles--such as high debts, slumping sales or poor management--in repaying the notes. Indeed, the current average default rate on junk bonds is only 2%.

But once a debt issue has been given a low or junk ranking by the rating services, it must offer a higher interest rate to attract investors. Currently, yields for investment grade bonds are running in the neighborhood of 12% and below. If the bonds your broker is recommending are offering 15%, you can safely bet that they have been given a junk rating.

However, this rating alone does not mean you should ignore your broker’s recommendation. Study the companies making the offerings. Just because they are national and well known doesn’t make them immune from default. You should read financial reports prepared by the professional staffs of several brokerage houses for a variety of perspectives on the company’s business and future prospects. Don’t limit yourself to the analysis of the brokerage house where you keep your account. Check the periodical section of your local library for current information about the companies.

Although labeled junk, these bonds could be a fairly lucrative, and potentially sound, investment if you are blinded neither by their label nor their attractive interest yields. However, most investment advisers strongly recommend that you hedge your bets by buying into a junk bond mutual fund rather than limit yourself to one or two issues. Although a 2% default rate is low, if you’re part of it, you could stand to lose substantially. Diversifying your junk portfolio in a mutual fund gives you additional protection with these admittedly risky investments.

Q: Is it true that I can withdraw funds from my individual retirement account and redeposit them up to 60 days later without any penalty or tax liability? If so, then it seems that I can withdraw the proceeds and invest them for 60 days outside the IRA and the interest earned during that time can be used immediately, instead of waiting until I am 59 1/2 years old. Right?--S. K. L.

A: Right. The laws governing IRAs allow holders to transfer their money from one account to another once a year, providing that the move is completed with 60 days. As a practical matter, this does mean that you could withdraw money from your IRA, invest it for 60 days outside an IRA account and redeposit the principal 60 days later without incurring a penalty. Interest earned during the 60 days would be immediately available for use. However, it would be considered a part of your annual income, and you would be liable for federal and state taxes on it. Unless your IRA is really quite large, you probably won’t make much money in just 60 days.

If you’re really serious about tapping the full power of your IRA, you might want to consider it as a source of short-term financing for an investment opportunity. Let’s say a terrific opportunity comes your way and you are short of cash but expect a bonus check or other payment within 60 days. You could use your IRA funds and replace them when the money you are expecting arrives.

However, you should be absolutely sure that you can replace the funds within 60 days or you are liable for penalties of up to 10% of your principal. Further, you probably don’t want to put your retirement funds at serious risk by making speculative short-term investments.

Finally, experts caution that repeated transfers of large sums in your accounts could trigger an audit from the Internal Revenue Service, and in the worse case, the IRS could change the current laws to prevent such activities. Be careful out there.

Q: I want to sell my house and I expect to realize a total profit of $215,000. If I take the $125,000 tax exemption available to senior citizens, I will still have $90,000 that is subject to taxation. Can I invest that $90,000 in another house within two years to avoid paying taxes on it?--W. W. P

A: No, to avoid any taxation on profits from the sale of your residence, you must buy a home of equal or greater value than the home you sold. You may not divide the profit in the manner you propose; the entire amount must be applied toward the purchase of a new home within two years of the sale.

So, if the profits from the sale of your home are $215,000 and you do not buy a home whose price equals or exceeds that of the home you sold, you would still be liable for taxes on $90,000 even after using the one-time tax exclusion of $125,000 allowed by both the state and federal governments.

Last Saturday, a reader asked how he should calculate the taxes he owes to the state of California for individual retirement account withdrawals that he is making. He noted that when he opened the $2,000 account in 1982, IRA contributions were not considered tax-deductable by the state. Since 1982, his account has grown to $4,147, including interest, and he wondered how he should handle the state taxes on the $191.15 he draws from the account each year. He has already paid taxes on the $2,000 initial contribution but not on the accumulated interest. The answer provoked a small flurry of reader criticism, and a spokesman for the state Franchise Tax Board called to say his response was erroneous.

Here is the spokesman’s revised response: According to a law passed in February, taxpayers may simply consider the first $2,000 withdrawn from the IRA account as tax-free income. The remainder would be fully taxed. This system is called the Cost Recovery Method. The original answer said taxpayers should ask their savings institution to allocate the disbursements between principal and interest and pay taxes only on the interest.