High Yield ("Junk") Bonds

Junk bonds, and the mutual funds that own them, are an often misunderstood asset class. These high yield bonds offer higher yields (returns) to investors because of the higher risk of default that accompanies them. In general, though, they still stand senior to common stock, so in theory they are less risky than stocks, and are almost certain to have less risk than stock in the issuing company.


Are these appropriate investments for conservative retirees? They are at least as appropriate as stocks. Any investor who is willing to take market risk and be in the stock market, ought to be familiar with opportunities to invest in junk bonds. On the other hand, like most asset classes, the timing of purchases and sales is the most important determinant of investment returns, so investors need to be wary.


Particular now, as 2007 begins, junk bond investors ought to go in with both eyes open. High yield investors get current income, from bond coupons, and the potential for capital gains or losses resulting from price moves of the underlying bonds. If a bond is at risk of defaulting, the price of the security falls. If this credit risk declines, the price of the bond may rise. Changes in the underlying price of the bond can provide investors with equity-like gains on the upside, and losses that more than wipe out coupon income in the event of a default.


As 2007 begins, the extra income associated with buying a junk bond (the so-called "yield premium") is very narrow. Junk bond investors aren't requiring much extra yield for accepting the higher default risk. In the January 2007 issue of Institutional Investor, Carnegie Corp. Chief Investment Officer, Ellen Shuman, notes that we're "seeing a lot of triple-C debt issuance. People have forgotten that 50% of triple-C debt defaults over a 10-year period."


If defaults rise, the price of all junk bonds might fall to better reflect the risks, and the extra income that junk bond investors receive could quickly be offset by capital losses. We're already seeing sub-prime lenders increasing loan loss provisions. It shouldn't come as a shock to high yield investors if junk bond prices get hit as well.


Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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