Want to be the most popular person on Wall Street today? Put in a bid for a junk bond. Junk-bond prices haven't collapsed, in part because everyone is too scared to trade them.
If you own a junk-bond fund, it's probably too late to sell. You might consider adding to your holdings over the next few months, though.
Remember, bonds are long-term debts that you can buy or sell. A $1,000 30-year Treasury bond is a $1,000 loan to the U.S. government. If you had bought your $1,000 T-bond when the government sold it in May, you'd receive 5% interest, or $50, every year until May 2037. At that point, the Treasury would return your $1,000 principal.
If you buy the bond now, though, you'll pay more than $1,000. Why? Because bond traders think long-term interest rates will soon fall. If rates fall to 4.5% at the next Treasury auction, your 5% T-bond will suddenly look mighty attractive.
A bond's interest payment is fixed, which is why the bond market is sometimes called the fixed-income market. Traders can't change your bond's $50 annual payout. Instead, they'll push your bond's price up or down to adjust its yield — the interest payment divided by the price. If your T-bond's price moved up to $1,100, for example, its yield would fall: $50 divided by $1,100 is 4.5%. Conversely, if your T-bond's price fell to $900, its yield would rise: $50 divided by $900 is about 5.6%.
The Treasury is considered the safest borrower on the planet; a default would be unthinkable. When you deal with corporate bonds, however, you do have to think about default. If you buy a 30-year bond issued by the fictitious International Infindibulum, for example, you have to wonder whether the company will be able to repay its junk-rated debt.
Wall Street employs legions of people to determine a company's ability to make timely interest payments on its bonds and to repay principal once those bonds mature. Companies with good credit ratings pay a bit more interest than the Treasury does. (Their credit is good, but they're still not the U.S. Treasury.)
Companies with poor credit must pay higher rates to compensate investors for the risk of default. Those risks are considerable. In the 12 months that ended in June — a period of easy credit and low defaults — the default rate for junk bonds was 1.5%, Moody's says. And even a 1.5% default rate is more dangerous than it seems, because the rate is cumulative: At a 1.5% default rate, a portfolio of 100 junk bonds would see 14 of its bonds evaporate in 10 years.
Junk-bond issuers have to pay high yields to lure investors. As of the end of July, the average high-yield bond fund yielded 7.15% — pretty juicy at a time when most other investments yielded 5% or less.
But yields weren't juicy enough, says John Lonski, chief economist at Moody's. Traders typically look at a junk bond's yield compared with a Treasury security of similar maturity. Junk yields were an average 2.75 percentage points higher than Treasuries in June, which isn't very much.
"Investors were being undercompensated for risk," Lonski says. By Moody's estimation, yields should have been about a percentage point higher — meaning, too, that prices should have been lower.
That problem seems to have righted itself. Junk-bond prices are lower, and yields are higher. Junk-bond funds — the most popular type of bond fund — have gained just 0.4% this year, including reinvested interest. For investors, the question is whether they'll gain further.