This Day On The Street
Continue to site
ADVERTISEMENT
This account is pending registration confirmation. Please click on the link within the confirmation email previously sent you to complete registration.
Need a new registration confirmation email? Click here

How Junk Bonds Got Their Name

NEW YORK ( ETF Digest) -- Junk bond ETFs have seen record inflows of investor money over the past year, growing as much as 68%, but investors may not be aware of the substantial risks that junk bond investments pose.

There are a number of reasons for this massive influx of cash, not least of which is the reluctance many investors feel about putting money back into the stock market after getting burned in the recent financial crisis. With U.S. Treasury bond yields at historic lows, held down by continuing low interest rates from the Fed, many investors, particularly aging baby boomers, are turning to junk bonds and junk bond ETFs for extra returns.

Of course, they're called "junk bonds" for a reason. Any bond rated less than "BBB" (Standard & Poors) or "Baa" (Moody's) falls under the junk bond category. They pay higher yields because the borrower has poorer credit; they have no other option and must pay higher interest rates. This extra yield (historically with coupons 4% to 6% higher than Treasuries) sounds appealing until you factor in the substantially higher risk of default. It could be that you (or the ETF) make a higher current return, or it could be you lose everything when the borrower can't make the payments and defaults. Of course, with a diversified fund, some poor outcomes can be absorbed but not many.

Follow TheStreet on Twitter and become a fan on Facebook.

Junk bonds are also in a precarious spot with regard to the macroeconomic picture. When or if interest rates rise (and they almost certainly will have to eventually) junk will feel the pain first and most, as their borrowing costs rise, increasing the risk of default. Conversely, if the economy should weaken, this would also affect the bond issuer's ability to pay interest, and they could (are you noticing a pattern here?) default.

Another thing to keep in mind is that most non-Treasury bonds are "callable," which means the issuer has the right to redeem them at a set price (usually at par or slightly greater) and call date. This limits appreciation potential because if interest rates fall (of course they're already low) issuers will call them in and issue new bonds (just like refinancing a mortgage for a lower rate).
1 of 2

Check Out Our Best Services for Investors

Action Alerts PLUS

Portfolio Manager Jim Cramer and Director of Research Jack Mohr reveal their investment tactics while giving advanced notice before every trade.

Product Features:
  • $2.5+ million portfolio
  • Large-cap and dividend focus
  • Intraday trade alerts from Cramer
Quant Ratings

Access the tool that DOMINATES the Russell 2000 and the S&P 500.

Product Features:
  • Buy, hold, or sell recommendations for over 4,300 stocks
  • Unlimited research reports on your favorite stocks
  • A custom stock screener
Stocks Under $10

David Peltier uncovers low dollar stocks with serious upside potential that are flying under Wall Street's radar.

Product Features:
  • Model portfolio
  • Stocks trading below $10
  • Intraday trade alerts
14-Days Free
Only $9.95
14-Days Free
Dividend Stock Advisor

David Peltier identifies the best of breed dividend stocks that will pay a reliable AND significant income stream.

Product Features:
  • Diversified model portfolio of dividend stocks
  • Updates with exact steps to take - BUY, HOLD, SELL
Trifecta Stocks

Every recommendation goes through 3 layers of intense scrutiny—quantitative, fundamental and technical analysis—to maximize profit potential and minimize risk.

Product Features:
  • Model Portfolio
  • Intra Day Trade alerts
  • Access to Quant Ratings
Options Profits

Our options trading pros provide over 100 monthly option trading ideas and strategies to help you become a well-seasoned trader.

Product Features:
  • Actionable options commentary and news
  • Real-time trading community
SYM TRADE IT LAST %CHG
AAPL $122.79 -0.16%
FB $95.00 -2.10%
GOOG $633.00 0.17%
TSLA $266.88 1.20%
YHOO $37.48 -0.50%

Markets

Chart of I:DJI
DOW 17,745.98 -5.41 -0.03%
S&P 500 2,108.63 +0.06 0.00%
NASDAQ 5,128.7850 +17.0520 0.33%

Free Reports

Top Rated Stocks Top Rated Funds Top Rated ETFs