Money is rapidly flowing out of high yield bond funds, which are composed of bonds rated below BBB by Standard & Poors and below Baa by Moody’s. With Europe looking shakier, investors have sought the safety of U.S. Treasuries. After a four-month buying surge beginning in January, more than $3 billion left high-yield bond funds during the week ended May 23. Some are calling on investors seeking yield to put money into high-yield bond funds (“Is Now the Time to Buy Junk?,” by Ken Levisohn, Wall Street Journal).
Others also urge caution. “It’s not the optimal time to add risk,” according to Brad Rogoff, head of credit strategy at Barclays, as a worsening of the Euro crisis could lead to more selling of junk bonds.
Even during stable markets, high-yield (junk) bonds are considered to be speculative, high-risk investments. High-yield bonds can be volatile. “These aren’t certificates of deposit. You have to be comfortable with some volatility,” according to William Larkin, a fixed income manager.
High-yield bonds and stocks have similar market risk and return characteristics. High-yield bond prices have a much greater correlation with the movement of stock prices than with investment grade bonds. Thus junk bonds do not add the benefit of diversification that investment grade bonds do.
Junk bonds also have credit risk ? the risk that the issuer will default on its payments. Investors therefore demand higher yields than they do for investment grade bonds as compensation for the increased risk of default.
Perhaps most alarming, junk bonds are generally illiquid, meaning there is not always a ready market in which to sell them. The lower the bond’s rating, the less liquid the bond is. This illiquidity can be more pronounced in periods of market stress.
Investor attorney J. Boyd Page commented: “Investors and their advisors need to consider all the risks, particularly the liquidity risks that may be realized if the Euro crisis breaks bad. It could lead to an even more serious run to exit junk bonds. If that happens, investors could have to sell these bonds at fire sale prices. It could get ugly for junk bond and junk bond fund investors in a hurry.”
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.