Tempted by junk bond yields? Beware of inflation

If you've ever been trapped in traffic and 40 minutes late for a meeting, you know that the wrong question to ask is, "How can things get any worse?" That's usually when the raccoon in the back seat wakes up.

In investing, matters can always get worse, so if you're considering a move into junk-bond funds, you might take a moment to ponder what else could go wrong — such as a burst of inflation.

Junk bonds are long-term, interest-bearing IOUs issued by companies with dubious credit ratings. In some cases, the bonds have been issued by once-strong companies that have fallen from the top tier of the credit ratings — fallen angels, as they're called in the bond market. Other junk bonds were issued by companies that were shaky from the outset.

Whether it was born to junkiness, or had junkiness thrust upon it, a junk bond invariably offers higher yields than bonds issued by companies with higher credit rankings. The reason: The only way a junk bond can attract investors is to offer high yields.

And in general, junk bonds' high yields have made up for a multitude of sins. On average, 4.9% of all junk bonds default each year. But the Lipper high-yield fund index, which measures the returns of the largest junk funds, has gained an average 7.8% per year in the past five years.

In contrast, the average money market fund has gained 2.1% a year over the period. The Lipper government securities fund index has gained 3.6% a year.

But the credit crisis has not been kind to junk-bond funds. Investors have worried that a slowing economy would force more companies to default. When investors worry about defaults, they demand higher yields — which they get by chopping junk-bond prices.

Let's say Raccoon Industries, a start-up company that makes flimsy trash-can liners, issues bonds that yield 6%. The deal: You buy a $1,000 bond, and Raccoon Industries pays you 6%, or $60, every year. When the bond matures, you get your $1,000 back.

Now, say that Raccoon Industries posts a big loss, and the ratings agencies cut the company's credit rating. You decide to sell your bond before it matures.

Your broker reports, however, that other investors are viewing your bond like a week-old mackerel. The best bid for your bond is $800. Because the bond will continue to pay $60 a year in interest, the buyer will get a 7.5% yield — the interest payout divided by the bond's price. You, however, will take a 20% loss on the price of your bond.

In this instance, you were somewhat fortunate, because you actually got a bid. During the worst of the credit crisis, bids for anything with less than stellar credit were hard to come by. "There was a significant lack of liquidity," says Dan Fuss, star manager of Loomis Sayles Bond fund.

At the height of the credit crunch, yields on high-yield bonds were 8.47 percentage points above Treasury securities with comparable maturities. In other words, if a 10-year T-note yielded 4%, a typical 10-year junk bond yielded 12.47%.

In the past few weeks, the junk-bond market has recovered a bit: Junk yields are about 6.5 percentage points higher than comparable Treasuries, according to Moody's Investors Service. John Lonski, Moody's chief economist, thinks the rally may be short-lived. "It's too early to declare the credit crunch over," Lonski says. "And there's no tangible evidence that home sales have bottomed."

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.