As the market swings, junk is king

By Tim Middleton

In a further sign investors are looking beyond a weak economy to a strong recovery, junk bonds are rallying briskly.

And if you're still nervous about today's market, junk bonds offer a beautiful blend of more opportunity than other fixed-income investments and less risk than stocks.

This worst-performing fixed-income-investment group of the past year shot up 2.9% in the 30 days that ended May 6 -- a better performance than small-company stock funds, according to Morningstar. Yields are already falling as bond prices, their reciprocal, rise.

"Right now we're about 650 basis points over Treasurys; that's a tightening of 150 basis points in the last four weeks," says Greg Hopper, the manager of Julius Baer Global High Income A (BJBHX), one of the best funds in this space. That's a huge, but shrinking, 6.5-percentage-point advantage over government bonds.

All this marks a particularly attractive opportunity for income investors right now.

Today's high yield, tomorrow's high price

The yield you'll get is the one you lock in when you buy the bonds, just as you lock in the rate on a certificate of deposit. But these bonds have a big advantage over CDs: Bond prices can go up, increasing your capital even as you coast along with yields much higher than latecomers can find.

Average gross yield on junk bonds -- the money you earn for owning them -- is now as high as 9.6%, and yields at diversified junk-bond mutual funds, after expenses are deducted, are in the 7%-to-8% range.

Over the past five years, the average junk-bond fund has delivered annualized returns of 7.5%, roughly twice the return of investment-grade bond funds and with 45% less risk than stocks.

Yes, despite their name, junk bonds are less risky than stocks because they have a much higher claim on a company's assets. Indeed, in bankruptcies, existing stock is erased and new stock issued -- to bondholders.

If you are an income investor, junk bonds are particularly appealing because competing bonds offer miserly returns. Treasury bills offer 1.67%, and high-quality bonds, represented by iShares Lehman Aggregate Bond (AGG), yield 3.85%.

And if you're nervous about junk bonds, which have had a bad name since Michael Milken went to prison almost two decades ago, don't be. They're just bonds issued by companies looking to raise money. Yes, they carry higher risk than top-tier bonds, but when the bonds are gathered into mutual funds, that risk is cut significantly.

Excellent junk-bond mutual funds are abundant. Nearly every mutual-fund complex offers a good one. Among the names I can recommend are Northeast Investors (NTHEX), T. Rowe Price High Yield (PRHYX), Pimco High Yield D (PHYDX) and Loomis Sayles High Income A (NEFHX).

Not junk companies

Junk, or below-investment-grade, bonds are actually the most common kind of corporate bond. Relatively few companies have investment-grade ratings. Among the holdings of the Julius Baer fund are Chesapeake Energy (CHK, news, msgs), General Motors (GM, news, msgs), Wynn Resorts (WYNN, news, msgs)and Hertz Global (HTZ, news, msgs).

Because of their poorer quality, junk bonds are much more likely to default -- to stop paying interest -- than high-quality paper. Thanks to years of strong economic growth, the U.S. default rate today is very low, about 2.1%. Moody's expects it to rise by next year's first quarter to 6%, which would be about average.

Continued: Averages are deceiving

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