High Yield “Junk” Bonds and Funds

Junk bond investments are usually unsuitable for the average investor. A junk bond is generally defined as fixed-income debt with a higher yield. These products are deemed non-investment grade which means they have poor ratings as determined by the big three rating agencies. For example, if Standard & Poor's (S&P) or Fitch rates a bond BB or lower its deemed junk. Moody's threshold for junk bond status is Ba or lower. Using the S&P standard, anything BBB or above is considered non-junk or "investment grade." It should be noted many consumers have been burned by the BBB rating as it is often misrepresented as investment grade. Though technically true, the problem is those bonds are just one notch away from junk status.

What is routinely omitted from junk bond presentations is that with high yields also comes high risks. One major risk is bankruptcy. However, a more common dilemma is that the rating agencies simply further downgrade the bonds, for example from BB to B. When this happens, the prices of the bonds will drop in value. If the bond is long term, its maturity date may be out of range for elderly investors. Even if the bond maturity date is close, there is always the risk that the security could get restructured which may push out to a new maturity date. Remember, the bond was downgraded because the rating agencies determined that the entity was in poor financial condition or at least in a deteriorating situation.

Most consumers do not invest directly in a junk bond. At least they should not be invested directly in such bonds. Consumers are generally investors in high-yield bond funds, which is another phrase for junk bond funds. These funds can be very volatile and are subject to market conditions to a greater extent than the average bond fund. Open-end bond funds are subject to redemptions which cause forced sales within the portfolio. Closed-end funds, which generally trade on an exchange, are subject to whim sales by conservative investors who get scared by volatility. Moreover, closed-end funds can be leveraged. The leverage causes internal sell-offs in down markets which is very bad for the portfolio. A leveraged high yield bond fund is a very speculative investment and is likely unsuitable for the majority of consumers.

In general, conservative or even moderate investors should not invest in high yield bonds or bond funds. Retirees especially should avoid such investments as the recovery time could be quite lengthy, and that is assuming the junk bond/fund does recover. In today's low-interest-rate environment, consumers are constantly looking for a reasonable rate of return without taking on undue risk. Unscrupulous financial advisors or stock-brokers may misrepresent the true nature of these types of bonds/ funds. A common sales pitch is that the fund manager can manage the risks of the high yield fund or the advisor himself can manage the risk of the client's portfolio of individual junk bonds. The fact of the matter is that such promises are practically impossible to fulfill. The end result is the innocent consumer is left holding the bag and is the one that suffers the losses in retirement savings. It is quite common for financial advisors/brokers to use the modest yield increase of high yield bonds/funds as a means of enticement to get clients in the door, all the while downplaying the risks. As an investor, you relied on the representations of your trusted advisor that the bonds/funds were reasonably safe. Most fixed-income investors are not looking for a big payday. They are simply looking for a reasonable rate of return.

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Shepherd Smith Edwards and Kantas has been representing consumers for over 30 years. There have been a number of bond related crises over the past few decades. In each one of them, we have been at the forefront of litigation representing wronged consumers. Our experience in this particular field is matched by few firms nationwide.

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