Why Junk Bonds Look Appealing

Should you stock up on this riskier but potentially higher rewarding asset class?

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So-called "junk" bonds may be the unpolished jewels of the fixed-income market, now that government bonds and higher-rated company-issued bonds are offering scant yield.

Experts predict a slow-and-steady pace of economic growth over at least the next year or so, which could keep a lid on interest rates and accordingly, yields. At the same time, mounting inflation risks due to ultra-accommodative global interest-rate policy mean longer-term investors will need higher yields to counter inflation's erosion of bond payments over time.

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The recent price decline in high-yield bonds, as junk bonds are officially called, is attracting fund managers and investors who want to stock up on this riskier but potentially higher rewarding asset class, says Michael Collins, senior investment officer at Prudential Fixed Income.

Individual investors can best gain access through mutual funds, where money managers diversify by including company-issued debt from multiple business sectors and by folding in bonds with credit ratings in the top tier of the junk category. That way, a default from individual holdings won't necessarily sink the whole fund.

High-yield bonds are perceived as riskier than treasury-issued debt and the bonds sold by companies with higher credit ratings—the letter grades that Standard & Poor's, Moody's Investors Service, Fitch Ratings, and others hand out. That's because high-yield bonds, which are graded below Baa3 by Moody's and less than BBB- by S&P, carry greater odds that the company will default on interest payments and/or principal. By definition, then, investors demand higher yields as compensation for taking on greater risk.

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Yield is the annual percentage rate of return and is calculated by dividing the coupon interest rate by its purchase price. Yield and price move inversely, so greater demand for a particular bond drives up its price and lowers its yield. But bond investors largely gauge the relative attractiveness of company-issued debt by comparing it to how much government debt is yielding; the comparison is known as the yield spread.

In a basic comparison (not looking at specific bonds), average junk bonds today are yielding anywhere from 7 percent to 10 percent, depending on credit ratings. Compare that to 3.5 percent to 5 percent for higher-rated company debt, around 2 percent for 10-year treasury notes, and around 2 percent on the S&P 500.

There is also upside potential for high-yield bonds should business or economic conditions improve, such as capital appreciation in the event of a rating upgrade, an economic upturn, or improved performance at the issuing company. Investors may also find the low correlation between high yield and other bond categories attractive. High-yield bonds have typically offered equity-like returns over the long term, with less volatility.

"With equities, investors look for company growth. With bonds you look for stability, predictability of cash flows that tell you a company can make their interest payments," says Sabur Moini, manager of the Payden High Income Fund (symbol PYHRX).

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Moini explains that bond ratings typically move based on companies taking on debt, usually to fund acquisitions. His fund focuses on defensive sectors, including energy, healthcare, and consumer staples.

High-yield bonds and related funds have been high flyers over the past few years, but have pulled back slightly in recent months. The average high-yield corporate bond fund lost 5.6 percent in the third quarter, and year-to-date, the category is down 2 percent, according to Morningstar data. Higher-rated, multi-sector corporate debt funds fell 2.9 percent in the quarter, but remain just positive for the year. Junk bond performance is positive for the past month.

"With corporate-to-government spreads of some 750 basis points [7.5 percentage points], there's a lot of cushion there to be wrong," says Prudential's Collins. High yield "is priced for a 7 percent annual default rate and the default rate is actually closer to 2 percent."