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For the very brave, junk bond yields should be tempting

November 24, 2008 |  6:30 am

If the stock market can keep a rally going for more than day or two, there's another ravaged market that could benefit: corporate junk bonds.

Annualized yields on junk issues have rocketed to record levels, by some measures, as the bonds' prices have plunged.

The yield on an index of 100 junk issues tracked by KDP Investment Advisors reached 17.47% on Friday, up from 11% as recently as mid-September. The yield on a Merrill Lynch junk index topped 20% last week.

Any bond considered to be less than investment grade is branded "junk" -- meaning, a speculative security -- but some obviously are more speculative than others.

Fijunkbond22In the current despairing market environment, however, investors have been dumping junk issues across the board. That has devastated share prices of junk bond mutual funds, a popular investment vehicle for many individuals.

Some portion of the damage has stemmed from forced liquidations of junk issues by hedge funds, as clients demand their money back. But the underlying fear is that many more companies will be defaulting on their debts over the next few years, potentially wiping out bond holders.

The annualized default rate on U.S. junk bonds was just 3.3% in October, according to Moody's Investors Service. But Moody's projects the default rate to reach 11.2% of junk issues a year from now as the economy worsens.

Still, current yields on junk issues are pricing in an annual default rate on the order of 18%, said King Penniman, head of KDP in Montpelier, Vt. That would be worse even than the peak rate of junk defaults in the Great Depression, which was 16% in 1933, according to Martin Fridson, a junk expert and head of Fridson Investment Advisors in New York.

The market may yet be right. But if it's too pessimistic, the long-term payoff in junk bond mutual funds could be tremendous at these prices and yields.

If the stock market can get a lift, or at least stop falling, that could help support junk bond prices by signaling that investors' pessimism about the economy in 2009 isn't worsening.

At a minimum, investors who think particular stocks are bargains should look at the companies' bonds as well, Penniman said. If you can earn, say, a 13% annual interest yield on a junk bond of a company you think will survive, you may be happier with the bond than with the stock, he says.

(Although, no rational investor would own just one junk issue. That's why mutual funds, including exchange-traded funds like the SPDR-High Yield portfolio, make the most sense for individuals who want to own junk: diversification cuts risk.)

Unless an economic collapse is coming, Fridson says many junk issues at these yields are likely to be "good purchases if you can go to sleep for the next 12 months" and not worry about day-to-day price moves.

But he notes that, "As a practical matter, many investors can't do that" -- particularly hedge funds and other institutions with shell-shocked clients who can't bear the thought of more losses.

That means the junk market still is vulnerable to more forced selling, in addition to the default risk that will inevitably rise as the recession bears down. But you're being paid a lot more to take on those risks than was the case just two months ago.