Why Junk Bonds Won't Help You When Markets Go South

Last Updated Jun 3, 2010 3:12 PM EDT

Tomorrow, we'll finish our look at why corporate bonds may not be a great choice for your portfolio, but I thought this was important to share.

May was a difficult month for stocks as the S&P 500 Index fell 8.2 percent. This should be when the bond portion of your portfolio picks up the slack. However, that wasn't the case if you owned junk bonds.

When markets drop, this is when you need your safe bond investments to do well, balancing the risks of equities. If you were in very high quality bonds like Treasuries and highly rated municipal bonds, you probably balanced the risks pretty well. Yields on these investments fell (prices rose) as investors engaged in a flight to safety.

Unfortunately, that wasn't the case for junk bonds. While junk bonds have a relatively low positive correlation to equities on average, that correlation has a nasty tendency to dramatically increase at exactly the wrong time -- when equity risks show up. As I discuss in my book The Only Guide to Alternative Investments You'll Ever Need, that should come as no surprise as junk bonds are basically hybrid securities. While there's some unique risk, most of their risks are explained by risks common to equities and Treasury bonds.

May was the worst month for corporate credit since markets seized up in 2008. The Bank of America Merrill Lynch index data showed that the difference in yield between corporate bonds and Treasuries widened 44 basis points last month to 193 basis points, or 1.93 percentage points. Junk bonds lost 3.57 percent.

This is why I recommend limiting your fixed income holdings to Treasuries, government agencies, the higher end of investment grade corporate debt and highly rated municipal bonds. And the evidence suggests that if you're going to take more corporate credit risk, you should limit it to the shorter end of the curve and avoid callable bonds.

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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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