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.

"It's awful," says Andrew Feltus, manager of Pioneer Global High-Yield fund. "It can take a long time to get in and out of the market."

What's worse, prices are low. Bonds have fixed interest payments, and traders can't change that. But if they think there's a chance of default, traders demand to pay lower prices. That, in turn, increases the yield.

Suppose, for example, you had a $1,000 bond that paid 5% interest. And say the issuer's credit quality has slowly deteriorated, and now it's in junk-bond status. If you wanted to sell your bond before maturity, a trader might offer you $500 for the bond. The bond's yield — interest payment divided by price — would soar to 10%. And you'd get a quick lesson in why they call high-yield bonds "junk."

So far this year, junk funds have fallen an average 2.3%, a figure that includes reinvested interest. Is too late to sell? Probably.

"If you had sold any time in the last eight months, you'd be happy," Feltus says.

Now? Not so much. Junk bonds fare best when the economy is coming out of recession. Right now, the odds are better that we're just entering one. Moody's Lonski isn't willing to say that defaults will have peaked by the end of this year. "We have to be prepared for a yet higher default rate going into 2009," he says.

If you're a bargain-hunter, it still might be a bit early to wade in. High-yield investors typically look at the yield spread between junk and Treasuries. In a bull market for junk, the yield spread narrows. Last spring, for instance, the spread between junk and Treasuries was less than 3 percentage points.

In a bear market, spreads widen, sometimes to 10 percentage points or more. They're not there yet. "Valuations aren't at rock bottom, but they're within striking distance of rock bottom," Feltus says.

If you're adventuresome and can stand some volatility, you can collect yields of 6% to 11% in high-yield funds while you wait for the market to recover. If you're more cautious, you might wait for the junk-bond market to get trashed even more.

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.