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.

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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).

Naturally there are those junk bond proponents who claim that many bonds with junk status have been rated that way unfairly. After all, many investment grade bonds were downgraded to junk bond status during the financial crisis. A potentially bullish sentiment, certainly, but one to keep in mind.

HYG

One of the most popular junk bond ETFs (they prefer to call themselves "High Yield Corporate Bonds") is the iShares iBoxx $ High Yield Corporate Bond Fund ( HYG) with more than $14 billion under management. HYG tracks the iBoxx $ Liquid High Yield Index. One of the advantages of investing in a bond ETF vs. directly in junk bonds, is that a typical investor is going to have a difficult time cutting the "wheat from the chaff" so to speak, and you can bet the money managers at ETFs, who spend their whole days doing nothing but bond analysis, are going to make better picks than you. That may not be enough though; as mentioned previously, the entire junk bond class of investments carries substantially more risk than investment grade bonds because of potential defaults.

It appears that in certain market climates, junk bond ETFs such as HYG (blue) can provide performance superior to that of the S&P 500 (red). Although it is currently underperforming, HYG did very well from August-November 2011.