So, exactly what are junk bonds and why avoid them?  What they are is easy to answer.  They are debts of corporations with poor credit ratings assigned by agencies such as Moody’s and Standard & Poor’s.  Why you should avoid them gets a little trickier to explain, but the principal contention runs like this: Stay away because the companies that issue them have problems that make repayment uncertain.  In short, if things go bad, you can take a beating.

If it’s all that simple, what more is there to discuss?  You’d expect a prudent investor to avoid them like the plague.  Doesn’t that settle the matter?  Whoa, not so fast!  There are a lot of advisors who aren’t so down on this sort of investment.  And they don’t call them “junk bonds,” either.  Not at all!  To this group they are known as “High Yield securities.”  The proponents contend that the generous interest rates attainable will more than offset the risks.

That’s the crux of the argument.  From this point on the pros and cons are debated as the statistics unfold.  Let’s look at a few of them.  Over the past five years the average mutual fund that invests in such vehicles dropped in value by 10 percent, with some even worse: Morgan Stanley High Yield A off 58 percent and Delaware Delchester down 38 percent.  Also consider the default rate—this is where the bond interest installments fail to be met or the final principal payoff is not honored.  By late 2002, according to Fitch, a major corporate credit rating firm, of the roughly $100 million in such bonds issued in the past three years, approximately 40 percent defaulted.

Though the picture appears grim, there are a few bright spots, as some of the junk bond funds turned a profit.  Over the past five years the Neuberger High Income fund yielded 30 percent; the Columbia High Yield fund produced 21 percent; still others managed to hold their own.

So where does this leave us?  I can understand that with the conflicting data, many of you may simply choose to avoid this sort of investment on general principles.  With the uncertainty, I suppose I can’t blame you.  After all, as corporate America appears to be in the throes of corruption, who can you trust?  Well, I’ll tell you who: You, that’s who!

Let me put it bluntly: Investing in junk bonds need not be a crapshoot.  I’ve been in this market for a lot of years, and it’s worked for me.  But you must follow a few rules.  I’ll spell them out for you.

■  Avoid bond funds.  There’s nothing they can do for you that you can’t do better for yourself.

■  Purchase your bonds, customarily issued in $1,000 increments, from a brokerage firm offering a broad selection of company-owned or controlled issues that can be purchased from their daily-generated lists at a net price to you.  This might include such firms as Merrill Lynch and UBS PaineWebber or a discount broker like Charles Schwab.

■  Deal exclusively in bonds of major public corporations, preferably listed on the New York Stock Exchange (NYSE).   Select, from among established companies in healthy industries, bonds with remaining maturities in the range of two to five years.

■  Research each issuing corporation to verify soundness.  This requires that you check out per share earnings and trends over the prior five years, corporate assets and liabilities, and current news reports on the company’s fortunes.  This is all readily available on various financial websites.

■  Try to acquire bonds that can be purchased at discount or, at most, par.  If a premium must be paid, make certain its terms provide it cannot be called (paid off) early at an amount less than your purchase price.

■  I Favor bonds with Standard & Poor’s (S&P) ratings between A and BB+.  Here is where discretion becomes important.  Any bond rated less than BBB is technically a “junk bond” . . . and herein lies the benefit.  By failing to qualify as investment grade—BBB or higher—it’s excluded from many portfolios, so may be priced to attain a disproportionately higher yield.  What you want is an issue that fails to make the grade for reasons that do not render it unsound.

■  And finally, as you begin to accumulate bonds, review them regularly—monthly, I’d say—using the same criteria.  Though your original intent was to hold each to maturity, factors may change to make a once satisfactory choice less secure.  My rule of thumb is simple: If a bond you hold is no longer one that you would have chosen to acquire, then sell it at once.

Those are the rules.  I’ll season them up a bit with a testimonial.  In 1996 the homebuilder Kaufman & Broad suffered a money-losing year with its debentures downgraded to BB.  Thereafter profits returned, but its bond ratings lagged at BB+.  In June 1999 I purchased 25 bonds ($25,000), 7.75% coupon, due 10/15/04, for $24,800.  Thanks to falling interest rates during 2001, bond values rose, and I disposed of them in January 2002 for $25,800.  My profits—interest plus gain—amounted to $6,005, representing an annual return of 9.37 percent.  Not too bad, I’d say, during a period when most securities investors were losing their shirts. 

So I’ll repeat the title of this article: Junk bonds need not be a crapshoot.  And I’ll summarize by declaring: Thar’s gold in them thar bonds.