There's no joy in junk bonds

By Tim Middleton

You can run from stocks, but you can't hide behind bonds.

Not when the spark that ignited last week's Tuesday-Thursday market rout was the grim specter of inflation. Inflation is Agent Orange to investments -- it defoliates them indiscriminately.

I've been scrambling to find havens from this spring's financial turbulence and last week turned my attention to junk bonds. A strong economy boosts their fortunes because the companies that issue them have more cash for paying what they owe to bondholders.

And it was due to surprising economic strength that the European Central Bank raised interest rates last week and that the Federal Reserve signaled it was prepared to follow suit.

But junk will offer no refuge in today's market. Indeed, if you already own a high-yield bond fund, now's the time to sell it.

"Now that rates are starting to move higher, it's probably better to step away (from junk bonds) and see what happens," says Adam Topalian, a fixed-income-investment strategist for Lehman Bros. "If you own it, consider taking gains. If you're not in it, I wouldn't jump into it."

Last week I recommended that stock investors take profits and put them into a bank-loan fund, a type of bond fund that is relatively immune to higher interest rates. This week I'm recommending that bond investors do the same and ignore such chimera as junk in favor of even safer portfolios, ultrashort bond funds.

An about-face in outlook

Fixed-income investors experienced a sea change in sentiment last week. Bond guru Bill Gross, the chief investment officer of Pacific Investment Management, reversed his outlook and predicted that long-term U.S. interest rates will rise as high as 6.5% in coming years, from less than 5% two weeks ago.

Like pills from the pharmacy, bonds come with a lengthy warning statement that is both mind-numbingly complicated and completely accurate. An imaginary summary on a bond would read like this: For every unit of interest-rate risk, a bond's price will go down exactly as much as interest rates go up.

These units are called duration, which is similar to maturity. The more time until maturity, the more a bond will fall when rates rise.

The typical junk-bond fund, according to Morningstar, has a duration of four years. If interest rates go up 1.5 percentage points, the principal value of that fund will decline exactly 6% (4 x 1.5). Because such bond funds are yielding an average of 6.77%, that means the total return that such a fund is capable of delivering is 0.77%.

But that's not the end of it. When last week's carnage began Tuesday, high-yield bonds were riding the crest of a five-year wave that had taken their returns up to 9.8% annually, well above their historic average.

That's because yield-hungry investors had bid up their price; yield is the reciprocal of a bond's price. As of last Monday, junk-bond yields "were bumping up against the most expensive levels in their historical database," says Bob Auwaerter, the head of fixed-income-portfolio management for Vanguard Group.

Continued: A stay on the sidelines

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