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The rush to junk bonds: A 'dangerous game'

By Blake Ellis, staff reporter


NEW YORK (CNNMoney.com) -- Bond investors and traders continue to be lured to high-yielding junk bonds as ultra-safe U.S. Treasurys waft in a tight range.

An improving economic outlook coupled with easing corporate defaults rates are behind the rush to junk, which are rated below investment grade.

As of Monday, junk bond issuance totaled $173.6 billion, according to research firm Dealogic. That means the amount of debt issued so far this year already tops the full-year record of $163.6 billion set in 2009.

"We're getting a very strong reaction to corporate bond issuance," said Kenneth Naehu, managing director and head of fixed income at Bel Air Investment Advisors. "The higher yields are luring people away from Treasurys."

Yields on corporate bonds tend to be about 100 basis points higher than Treasurys, said Naehu.

In addition to the big returns, the default rate on high-yielding bonds dropped to 5.1% last month from 13.2% a year ago, according to Moody's Investment Services.

That may be all well and good for the short term, but Naehu cautioned that default rates will eventually rise again.

"Most people forget that it was only a year and a half ago when high yields were trading with an 18% default rate," he said. "And I think the reason [default rates] have dropped is less because of actual bottom line growth of sales and revenue but more to do with companies being able to extend their debt."

Companies are being extended significant lifelines as demand for junk bonds picks up but that could hurt investors if they ignore the high risk associated with junk bonds.

"It's a dangerous game," he said. "While there are a lot of opportunities in this area right now, there is also a lot of risk when people stretch to get yields without regard to long-term credit quality."

"It's a buy now, look later kind of scenario," he added.

Treasury yields slip: Meanwhile, Treasury yields have risen from yearly lows, but are trading in a tight range as investors remain cautious about the recovery.

On Monday, yields edged slightly lower ahead of the Federal Reserve's interest rate decision, due Tuesday.

The yield on the benchmark 10-year note fell to 2.72% from 2.75% late Friday. The 30-year bond yield dropped to 3.87%, and the yield on the 5-year note slipped to 1.43%. The 2-year note's yield edged up to 0.48%.  To top of page

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