While it’s true that junk bonds still pay more than most, the fact is that bargains on junk bonds are becoming more scarce. With interest rates extremely low, buying junk bonds because of the extra income that you will get from their high yield can be tempting, but before you do, it’s best to know exactly what situation you’re getting into.

When a company has poor credit they issue what they call junk bonds and the yield on these bonds tends to be better than those of other low risk debt such as treasury bonds. In the last few years however, the demand for junk bonds from investors has pushed up their prices and cut back on their yields. (The reason is that bond prices move opposite to their yield.)

While the long-term average is approximately 9.5%, junk bonds recently paid out only 5.8%, a gap between their yield and that of comparable treasuries that’s almost 2 percentage points below average.

What that means, given their low yields, is that a junk bond pullback is possible. In July and August of this year it actually happened for about two weeks when, due to worries about the Middle East and Ukraine, US stocks retreated. Since junk bonds tend to move along with stocks, they also pulled back. Even one of the best benchmarks for junk bonds, Bank of America Merrill Lynch US High Yield Master II index junk bonds, declined 1%.

Thankfully the damage caused was minimal, stocks recovered and the US High Yield Master II index has since returned to 5.3%. Unfortunately, that also means that junk bonds are still relatively expensive. According to Mark Freeman, the co-manager of the Westwood Income Opportunity fund, “there hasn’t been a dramatic repricing,” in junk bonds.

That being said, holding on to some junk bonds still makes sense because of their higher interest payments, but financial advisors are still being cautious. Junk bonds could still be damaged if the economy begins to falter or a drop in share prices of 10% to 20%, a stock market correction, happens.

Most financial advisors still recommend keeping approximately 3 to 8% of your portfolio in junk bonds. 2 of the best choices available right now include;

  • Osterweis Strategic Income Fund (OSTIX).
  • Vanguard High-Yield Corporate (VWEHX).

Point being, while dumping your junk bonds completely isn’t necessary, picking and choosing them correctly is a must.

Filed under: Bonds

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