Slowing economy scuppers junk-bond funds

— -- You've had a bad week. The new bumper on your car is going to cost $3,000. Your tooth implants will send your dentist to Aruba. Your pen pal in Nigeria didn't transfer $25 million to your bank account.

How could things get worse?

Oh, yeah. You own a junk-bond fund.

Every type of investment gets its turn in the shredder, and junk bonds are having their turn this year. If you own a junk fund, it's probably too late to sell now. If you're bargain-hunting, it's a bit early. But you might find a good buying opportunity soon.

Junk bonds are long-term IOUs issued by companies with dubious credit ratings. Junk-bond issuers have credit ratings from Moody's Investors Service that range from Baa ("may possess certain speculative risks') to C ("toast"). The equivalent credit ratings from Standard & Poor's range from BB to D.

Like people with low credit scores, companies with poor credit ratings must pay high interest rates when they borrow money, to compensate for the risk that they'll default. The U.S. Treasury, by comparison, can borrow money for 10 years at only 3.76% interest, because a government default is virtually non-existent.

A typical junk-bond issuer will have to pay about 7 percentage points more than the Treasury, or about 10.7% on a 10-year note. Those who invest in junk bonds must be willing to accept the risk that the company will default on its bonds. Should that happen, they will have to stand in line with the company's other creditors.

The current junk-bond default rate is about 1.1%, says John Lonski, Moody's chief economist. Companies don't default lightly, and the economy hasn't been quite sour enough long enough for lots of defaults. But with the economy slowing, he expects the default rate to climb to 5.2% by the end of the year. (The long-term average default rate is about 4.9%, Lonski says.)

Wall Street looks forward, not backward, which is one reason the junk-bond market has been so dismal. Trading volume is light, making it tough to buy or sell high-yield bonds.