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If Interest Falls, Will Junk Be Junk?

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The recent junk bond rally has drawn record billions of dollars to high-yield bond funds. What junk’s newfound fans might not realize is that their own frenzy has fueled much of these recent gains and that when interest in high-yield funds cools, the junk market may live up to its name.

“It’s been more of a technical rally than a fundamental rally, with money basically flooding the market and lifting all the boats,” says Sandy Rufenacht, manager of the $1 billion Janus High Yield Fund (JAHYX) since 1996. “It’s just not justified by the type of economy we’re in.” Junk, or high-yield, bonds, are debt issued by companies with a credit rating of double-B or lower because of short or spotty credit records. Since they are offered by companies with a lot of debt, less-than-perfect credit or both, they tend to pay far higher interest than investment-grade bonds, assuming the issuer doesn’t default.

Investors tend to chase high yields and returns, and so far this year they have done both. High-yield funds attracted $14.4 billion in new cash through April 30. That is more than any other fund category and just shy of high-yield funds’ net cash flows over the past two calendar years combined, according to Boston fund consultant Financial Research Corp.

Since the high-yield market is fairly illiquid, large influxes of money going into junk funds can boost prices as managers buy up securities with the new cash. Thus the worry that the big gains by junk bonds are largely because of investors’ chasing returns and that junk bond prices could start to sink when flows to high-yield funds slacken.