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Risk Averse Investors Pour $36 Billion into Risky Investment. We Explain.

How desperate are investors for a real yield? About $36 billion worth of desperate, according to fund flow data from Morningstar. In the 12 months through October, the $30 billion in net inflow into the junk bond category ranked #2, behind the $109.8 billion inflow into intermediate-term (high grade) bond funds. Bank loan funds -- another junky bond category -- took in an additional $6 billion.

In a world where Federal Reserve zero-interest-rate policy has made it impossible to earn any real yield -- the 10-year Treasury rate is well below 2% -- on standard-issue bonds, the income payout on high yield bonds (the polite term for junk) is proving too hard to resist.

10 Year Treasury Rate Chart

10 Year Treasury Rate data by YCharts

A dollop of junk on top of a large serving of high-grade bonds can be a sane way to eke out more yield. But frustrated investors who are making wholesale shifts into junk better be considering the downside. Junk bonds aren’t particularly sensitive to interest rate changes. Their kryptonite is economic sluggishness. In recessions junk bonds behave a whole lot like stocks, not bonds. Here’s how the SPDR Barclay’s High Yield Bond ETF (JNK) fared during a rough stretch in 2008-2009, compared to the high-grade Vanguard Total Bond Market ETF (BND) and the S&P 500.

JNK Total Return Price Chart

JNK Total Return Price data by YCharts

Recently, bank loan funds have been getting buzz as the better way to play junk. The yield differential between the two is pretty tight right now, and bank loans are being lauded for their better prospects in a down market.

Unlike straight-up junk bonds, bank loan funds -- also known as senior loan funds -- are collateralized debt, so in the case of default, bondholders are higher up the structure to get a piece of any proceeds. The PowerShares Senior Loan ETF (BKLN), which has grown to $1.3 billion since its spring ’11 launch, has a 4.4% yield compared to 5.9% for the SPDR Barclay’s High Yield ETF.

Anthony Valeri, market strategist at LPL Financial, recently noted that Moody’s data shows after default senior bank loan investors get 70 cents back on their dollar, compared to 40 cents for junk bond investors. On a relative basis that’s obviously a hell of a lot better. But are you investing in bonds for relative victories or absolute protection of principal? As the above chart showed, when bad news hits, junky bonds get slammed. Buyer beware.

Carla Fried is a contributing editor at YCharts, which includes the just-released YCharts Pro Platinum for professional investors.

Read more articles about: Investing Ideas  

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