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For what seems like forever, interest rates have been uncomfortably low for those trying to live off the income from their portfolios. Those low rates have pushed many investors into buying higher-risk assets to boost their income.
But lately, a huge number of investors who turned to the high-yield "junk" bond market for income have suddenly decided that it's time to get out. Are they making a smart move, or does their stampede away from junk bonds actually suggest it's the right time to buy?
Don't look down
Recently, all eyes have been on the struggling stock market, which posted six straight weeks of declines in May and June before finally stabilizing. But junk bonds actually saw an even more serious drop, falling on 13 straight days earlier this month. That's the longest streak since 2008's financial crisis, in which bond markets essentially stopped functioning.
As you'd expect, the long decline took a decent-sized bite out of junk bond prices. At its worst point this month, the iShares iBoxx High Yield Corporate ETF (NYSE: HYG ) had lost more than 4% of its value since the end of May, while the SPDR Barclays High Yield Bond ETF (NYSE: JNK ) had seen almost a 5% drop.
The junk rout has many investors running scared. Both mutual funds and ETFs that specialize in junk bonds have seen big outflows, with last week's mutual fund outflows of $3.4 billion at the highest level in nearly 20 years.
But inevitably, such a steep drop has also invited value investors to the table. A recent article in the Wall Street Journal points out that after long streaks of losses like this, the bond market has tended to rally. Moreover, with a combination of low interest rates and a slow but steady recovery, junk bonds are likely to be able to avoid seeing markedly high default rates. If those conditions happen, then investors will simply continue collecting the higher income payments that junk bonds offer.
Is one investor's junk your treasure?
It wasn't that long ago that junk bonds weren't offering very much in additional return over lower-risk bonds. With tight junk bond spreads, investors weren't getting much of an incentive to accept the higher probability of junk bond defaults. But with the fall in the junk bond market recently, those spreads have started to widen again.
Perhaps more importantly, if you want to invest in bonds, junk bonds are almost the only game in town. With high-grade corporate issuers Johnson & Johnson (NYSE: JNJ ) and Microsoft (Nasdaq: MSFT ) among those who were able to cash in on record-low rates by issuing low-interest bonds last year, investors simply aren't able to get the income they need from the highest-quality corporates. Investors in stocks with pretty good dividend payouts, such as IBM (NYSE: IBM ) and Wal-Mart (NYSE: WMT ) , get better yields from owning shares than they would from buying the bonds they've issued lately.
By contrast, junk bond yields are high enough to have an advantage over most dividend stocks. But those high yields haven't stopped cash-strapped issuers like Sanmina-SCI (Nasdaq: SANM ) from taking advantage of the favorable environment in bond yields lately. But with the two junk bond ETFs mentioned above paying a yield of about 8% right now, you're at least getting some additional income in exchange for the risk you're taking on.
Buy in moderation
As part of an asset allocation strategy, owning some junk bonds makes plenty of sense. Junk combines certain characteristics of both bonds and stocks into a single package, and as a result, they sometimes act a lot more like stocks than bonds as far as price behavior is concerned. If you think rates are destined to move higher overall, then the stock-like aspect of junk bonds may ironically make them a safer bet than "safe" Treasuries.
Junk bonds aren't the perfect answer to every income investor's concerns. But if the trend toward lower prices continues, then junk may finally give you a value opportunity worth taking advantage of.
On the other hand, if you don't have enough dividend stocks in your portfolio, you're probably making a much bigger mistake. To find a nice sample of 13 smart stocks that pay dividends, take a look at the Fool's special report on dividend stocks. Get your free copy today by clicking here.