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Junk bonds outperforming higher quality bonds and equities

Published: Monday, Aug. 27 2012 10:59 p.m. MDT

A thirst for yield on the part of institutional investors and individuals, along with relatively strong corporate balance sheets, has contributed to the year to date positive performance of lower quality bonds. Sometimes called junk bonds or high yield bonds, these lower credit quality debt instruments have returned just over 10 percent so far this year.

As reported for the Bank of America U.S. High Yield — Cash Pay Index, the current yield on this junk bond index is about 6.7 percent. This yield represents an increase in rate of over 5.75 percent above a comparable maturity U.S. Treasury bond. An incremental yield of 5.75 percent above the assumed risk free rate indicates a material amount of risk and concern about the ability of the underlying companies to make all the contractual interest payments and ultimately return the principal at maturity of the bonds.

As measured by the Dow Jones Industrial Average, U.S. stocks have returned a little under 9 percent thus far in 2012. The Dow index is made up of 30 higher quality stocks and is often used as the barometer of overall equity performance.

A bond index representing the broad, generally investment grade, bond market has returned about 3.5 percent year to date. This index includes U.S. Treasury securities, investment grade corporate bonds and residential mortgage backed securities primarily guaranteed by one of the U.S. government sponsored housing entities. The current yield on this broad bond market index is currently just over 1.6 percent.

As is commonly noted in the investment world, past performance is no guarantee of future performance. Some of the market and economic fundamentals driving the relative out performance of this high yield index are unlikely to continue indefinitely. Interest rates have generally decreased which has resulted in some of the price appreciation. Also, relatively strong corporate balance sheets and fairly stable earnings have caused investors to remain comfortable with the general default risk in these bonds. And of course, a wide ranging search for yield has resulted in the prices of these bonds being bid higher. Fundamental changes in one or more of these value drivers could result in relative underperformance of high yield bonds.

Kirby Brown is the CEO of Beneficial Financial Group in Salt Lake City.

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