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Why Would You Ever Enter the Junk Bond Market?

By Robert Barone and Dustin Goldade


NEW YORK (TheStreet) -- How are you getting yield in your portfolio?

The latest craze is through the junk bond market, where income starved investors are taking on more risk to generate only small amounts of yield. However, the mounting risks in the junk bond market are substantial relative to the return. The yields in that bond market are not only way below historic norms, but also below their historic default rates.

This means that junk bond investors should expect losses if they are in the market for the long term. Although default rates are low at the moment, junk bond issuers are highly cyclical and will be the first to crack when interest rates rise. The junk bond market is a trend, not an investment.

The Risks in the Bond Market

Market pundits are very focused on the potential of rising interest rates. Looking at the junk bond market, not only are there significant headwinds in terms of such interest rate risk but there are also default risks that investors need to be compensated for but are now ignoring.

The table below shows historical data on default rates on junk bonds, which highlights the looming concerns in this market.

Source: Standard and Poor's, St. Louis Federal Reserve

The real concern the table points out is in the B-rated and lower bond categories, where the average default risk is higher than the yield and where investors have been reaching for yield. Although default risks are now towards historic lows due to the Federal Reserve's zero interest rate policy (ZIRP), default rates are likely to revert back to their historic averages.

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