The Federal Reserve’s recent announcement of the new stimulus package has resulted in another stampede by investors into higher-risk high-yield (junk) bonds. Inflows into junk bond funds were the second highest ever and the highest for this year. Even lower grade borrowers are selling junk notes in the U.S. at an “unprecedented pace” (“Junk-Bond Fund Deposits Soar to Highest This Year as ETFs Lead,” Bloomberg). Low interest rates have forced investors looking to maintain reasonable yields to venture farther out on the riskier end of the investment spectrum.
Financial advisers recommending junk bonds need to carefully disclose their risks to investors. The market risk of junk bonds is similar to stocks, and junk bond prices have a much greater correlation with stock price movements than do investment grade bonds. The risk that the issuer will default on its payments (credit risk) is also higher for junk than investment grade bonds. Junk bonds are also less liquid than investment grade bonds. When investors want to sell junk bonds, there may not be a ready pool of buyers. This illiquidity is often worse in periods of market stress.
Page Perry is an Atlanta-based law firm with over 170 years of collective experience maintaining integrity in the investment markets and protecting investor rights.