A hidden risk in high-yield bonds

Flickr user Seth J

(MoneyWatch) In today's yield environment, I often get asked about high-yield bonds (often referred to as "junk bonds"). One of the drawbacks of junk bonds is that you need to own a lot of them to get sufficient diversification against company-specific risk. Big-time investors might be able to do this, but most of us are left to own high-yield bonds through mutual funds and ETFs.

The attraction of high-yield bonds is clear: They have had slightly higher returns and much higher yields than investment-grade bonds. (Of course, they also have higher risk that shows up at the absolute worst time, but that is a topic for a different blog post.)

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From December 2007 to October 2012, The Barclays Capital US Corporate High-Yield Bond Index outperformed the Barclays Capital US Credit Index by 2.2 percent per year. However, there's often a gap between results on paper and realizable results, because strategies don't have costs but implementing them does.

Junk bonds can be illiquid. This makes the asset class difficult to access in a low-cost manner. For example, since its inception on Nov. 28, 2007, the SPDR Barclays High Yield Bond ETF (JNK) underperformed its benchmark index by 3 percent per year. Thus, all of the gains from the risk of junk bonds were lost to management fees and the costs of implementing the strategy. This is yet one more reason why junk bonds aren't appropriate for most investors' portfolios.

Image courtesy of Flickr user Seth J