Tempted by junk bond yields? Beware of inflation

The average default rate for junk bonds the past 12 months is 2.1%, a figure that includes a fair chunk of time before the credit crunch started in October. "I could see the default rate moving to 5.5% by the end of the year, and being in the neighborhood of 7% by this time next year," Lonski says.

Eric Takaha, high-yield bond manager for Franklin Templeton Investments, thinks that rising defaults and weaker corporate earnings could mean a slow recovery for high-yield bonds. "I'm not sure, in the near term, how much price gain we'll see," Takaha says.

Even with flat prices, relatively high yields could make junk bonds appealing. How could things get worse? Fuss, unfortunately, has an answer: higher inflation. He frets that by pumping so much money into the system to stem the credit crisis, the Federal Reserve could re-ignite inflation next year — and that's poison for bonds.

Inflation erodes the value of a bond's fixed interest payments. When inflation rises, investors demand higher interest rates. They get those higher rates by — you guessed it — punching down bond prices. Fuss sees the yield on the 10-year T-note, currently 3.78%, rising to 6.25% in the next few years.

If you must have junk, look for funds whose portfolios have relatively high-quality bonds. You might even consider a fund that also dabbles in investment-grade corporate bonds. High-quality bank bonds, for example, offer solid yields and a relatively low chance of default. At any rate, stay away from funds with truly trashy portfolios. You'll earn a bit less interest, but you won't have quite as many nasty surprises.

John Waggoner is a personal finance columnist for USA TODAY. His Investing column appears Fridays. Click here for an index of Investing columns. His e-mail is jwaggoner@usatoday.com.

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