HIGH-YIELD JUNK BONDS can offer impressive interest payments. The question is, how big a price will you pay in defaults? Junk bonds receive a rating of Ba1 or lower from Moody’s Investors Service, or BB+ or lower from Fitch Ratings and Standard & Poor’s. That means these bonds are considered below “investment grade”—and there’s a serious risk you won’t get your money back. Historically, some 5% of junk bonds have defaulted each year, though defaults in recent years have been running at more like 2% or 3%.
To compensate for the risk of defaults, junk bonds have, on average, yielded some six percentage points more than comparable Treasury bonds. But the spread over Treasurys has fluctuated widely. In early 2007, it was below 2.5 percentage points. A year and a half later, in November 2008, the spread widened to almost 20 percentage points amid the panic selling of the financial crisis.
At the end of 2022’s first quarter, the spread stood at 3.3 percentage points, down from 8.8 points two years earlier. Junk bonds tend to trade more like stocks than bonds and, indeed, the tumbling stock market of early 2020 was accompanied by falling junk-bond prices, as investors worried that a shaky economy would cause a spike in bond defaults.
While there are some exchange-traded index funds that focus on junk bonds, most junk-bond funds are actively managed mutual funds. As you pick among them, pay attention not only to fund costs, but also to the credit quality of the portfolio. You can get the necessary information at Morningstar.com. A fund that focuses on lower-quality junk bonds will often sport a higher yield. But that higher yield may prove to be scant compensation if there’s a flurry of defaults.
Our Humble Opinion: Junk bonds seem like an unhappy compromise between stocks and bonds. How so? The time to buy junk is during economic downturns, when concerns about defaults drive up yields. Problem is, that’s also the time when you want to buy stocks—and stocks are likely to deliver better returns as markets rebound in anticipation of an economic recovery.
Next: Floating Rate Loans
Previous: Preferred Stock
Article: Garbage In