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A Rare Deal in Junk Bonds?

Despite some wild stock swings this week, overall market volatility remains low. Not that you’d know it by looking at the junk bond market.

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After a jump earlier this week, the CBOE’s volatility index – commonly known as the VIX, ominously called the “fear index” – fell on Thursday as the Dow rose more than 200 points in early morning trading. The index now stands at 18, below its long-term average of 20. But in what many bond experts say is a rare market occurrence, yields on junk bonds, which tend to drop with the VIX, remain elevated. “Apparently there is more fear in bond markets than in equity markets,” says John Lonski, chief economist at Moody’s Capital Markets.

Lonski and other investing pros say that fear is creating good deals for bond investors willing to take on some extra risk. High yield bonds, those issued to companies with the most debt, are currently yielding an average 6.4 percentage points more than comparable Treasury bonds. Historical trends going back to 1990 suggest that yield advantage should be closer to 5 percentage points when the VIX is at 18. “High yield does offer some value right now,” says Brian Rehling, chief fixed-income strategist for Wells Fargo Advisors.

Junk bonds also look especially appealing as yields on safer bonds hit record lows, say analysts. At 1.43%, the 10-year Treasury is now below the 1.45% record set on June 1.

Of course, nervous investors could ditch high yield bonds along with equities if fears rise suddenly, which could lead to losses for bondholders. Many investing pros also argue that stocks have a greater potential for higher returns in the long run. Compared to bonds, which investors have poured into since the financial crisis, stocks look attractively priced, says David Kelly, chief global strategist for J.P. Morgan Funds.

Still, some investing pros argue junk bonds may offer less volatility than stocks in an environment of slower economic growth. “You generally don’t have as much risk in high yield as you do in the equity markets,” says Rehling.  For extra cautious investors, Lonski says a sweet spot may be medium-grade bonds, which should still offer better yields than the highest-rated bonds but less default risk than junk bonds.

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    • Bond fund earnings compound, stocks funds do not. But shhhh…don’t tell anybody. :)

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