Junk Bonds Are Just That -- Junk

Last Updated Apr 27, 2009 3:09 PM EDT

With interest rates on safe Treasuries at exceptional lows, many of you may be tempted to turn to junk bonds to try to capture additional yield in your bond portfolios. The junk bond market has seen an uptick in activity recently for that very reason. However, this isn't a good idea.

The main role of fixed income in a portfolio is to provide stability, which is especially important during years like 2008. The danger of straying from this strategy and stretching for yield is that the risk of junk bonds may show up precisely when stability is needed most.

Events last year reinforced this idea. Below are the 2008 returns of the 10 worst performing municipal bond funds and the 10 worst performing taxable bond funds, courtesy of Morningstar. As you can see, investors that stretched for yield paid a severe price.
10 Worst Performing Municipal Funds 10 Worst Performing Taxable Funds Note that the losses on the 10 worst taxable bond funds and the three worst municipal bond funds were all worse than the 37 percent loss of the S&P 500 Index in 2008.

There are two lessons you should learn from the experience of 2008. The first is to never confuse yield with return. The second is that credit risk is correlated to equity risk. When the risks to equities shows up, credit risk tends to rear its ugly head at the same time. Thus, credit risk and equity risk don't mix well together in a portfolio.

That is why I recommend limiting fixed income investments to only Treasuries, government agency debt (generally avoiding corporate bond risk) and the highest investment grade municipal bonds (AAA/AA). If you followed this strategy, you not only would have avoided the severe losses many experienced, but you'd have actually seen the value of your fixed income investments rise in 2008.
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    Larry Swedroe is director of research for The BAM Alliance. He has authored or co-authored 13 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.

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