RISKS OF JUNK BONDS

High-yield bonds are usually issued by small companies undergoing a restructuring, merger or buy-out. The best ways to protect against defaults are to carefully analyze the credit of the company and to diversify by investing in bonds from different industries. But there are other risks to watch out for besides default. A second risk of high-yield bonds is in their liquidity, the ability to trade bonds at stable prices. Investors often find that they must hold onto junk bonds rather than sell them because they come from small companies and, consequently, are not as easily traded in the market place. This leads to low liquidity and higher transaction costs. The trade-off, of course, is the higher yields.

The third thing to consider about junk bonds is the general price volatility and instability of the junk bond market. Credit quality can change unexpectedly, and because the junk bond market is so small, prices can go up or down in a heartbeat.

The value of your bond also goes down when interest rates go up. When interest rates go down, your bond increases in value. Interest rates are also tied to the inflation rate. An increase in the inflation rate often means an increase in interest rates, which deflates bond prices. When inflation is low, the default rate of junk bonds drops. Furthermore, high-yield bonds are not as influenced by interest rates as higher-rated bonds are.

Inflation can also decrease the value of your bond. The longer the maturity of the bond, the more inflation risk you face. Although junk bonds have the potential for higher returns on your investment, you must look at all the factors involved and decide whether the rewards are worth these risks.