With yields down in the fixed-income world, the appeal of high-yield (“junk”) bonds has gone up. In late 2003, total junk bond fund inflows for the year had reached nearly $25 billion. At that point, the average junk bond was yielding nearly 8 percent while investment-grade corporate bonds averaged less than 4.5 percent. Junk bond funds were paying over 7 percent.
There is credit risk as well as interest-rate risk in junk bonds. However, if the economy strengthens, the default rate on junk bonds likely will drop to acceptable levels. According to Moody’s Investors Service, the global junk bond default rate had fallen to 5.7 percent in late 2003, down from a peak of 10.8 percent in January 2002.
There is considerable disparity among junk bond funds. Some funds hold a lot of lower quality bonds, then mix in some high-quality bonds to boost the average credit rating. Investors need to dig in and find out what a fund holds, to learn about the level of credit risk.
