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

But averages in the junk market are deceiving. Junk bonds lurch from very low defaults in good times to as much as 10% in recessions; the market is usually only in between when it's migrating from one pole to the other. Similarly, yields can fall as low as 2 percentage points over Treasurys in fat times and soar as high as 12 points over when defaults are accelerating.

Yields go up to compensate investors for accepting the risk of default. They're going down right now because the risk of a really high default rate, as in 10%, is diminishing.

Most junk-bond funds invest strictly in American bonds, but Julius Baer (the company name is written Julius Bär in Europe) has 40% of assets overseas, including emerging markets, which account for 13% of total assets. It hedges most of its currency risk, the danger that the value of holdings will be moved by changing exchange rates. "We don't want this to become a currency fund," manager Hopper says.

Northeast Investors, managed by the father-son team of Ernest and Bruce Monrad, sports a yield of 8.19%. It has about half its assets in B-rated bonds, the second-highest within the junk universe, and most of the balance in lower-rated paper. According to its most recent report, it had nearly 10% of assets in two issues, Trump Entertainment Resorts (TRMP, news, msgs) and Cinemark (CNK, news, msgs).

A better class of junk

T. Rowe Price High Yield is a bit more conservative, with nearly 30% of assets in BB-rated bonds, the highest rating in the junk world. The fund got burned in 2007 on bank loans, a market segment that took particular punishment in the credit crisis. But manager Mark Vaselkiv has more than a decade of experience, and T. Rowe has a deep bench of credit analysts.

No fund complex has better bond credentials than Pacific Investment Management, and its Pimco High Yield sailed through the past 12 months in the top 8% of junk-fund managers. Founder William H. Gross can read credit markets like Warren Buffett understands stocks, and this fund went defensive long before the worst of the credit crunch came along. Morningstar analyst Lawrence Jones notes that this fund owns only one-third as much below-B credit as does the typical fund in the group.

Loomis Sayles High Income owns even less: Its average credit quality is BB because 30% of assets are in investment-grade bonds. That ratchets down the risk profile, but the fund still manages to yield 7.25%. This fund has about 13% of assets in foreign bonds, including some from Mexico, and top-tier (for the junk world) names such as Ford Motor (F, news, msgs) and Alcatel-Lucent (ALU, news, msgs).

The evening news would have you believe the economy is in a shambles, but the junk-bond market (and the stock market, for that matter) is saying baloney. The corporate profit gains that are needed to service debt, pay dividends and carry equity prices higher are widely seen as just around the corner -- as in, no more than six months or so away.

This is a great time to dive headfirst into the private sector. For bond investors, that means junk. It has already spent its time in the doghouse. Now it's back out in the sun.

Meet Tim Middleton at The Money Show

MSN Money mutual funds columnist Tim Middleton is speaking at several panels at The Money Show in Las Vegas this week. But if you haven't caught him there, he'll be among more than 50 world-class experts in more than 150 workshops during the 30th anniversary of The Money Show San Francisco, Aug. 7-10 at the San Francisco Marriott hotel. Admission is free for MSN Money users. To sign up, call 1-800-970-4355 and mention priority code No. 009553, or visit The Money Show San Francisco's Web site.

At the time of publication, Tim Middleton did not own or control shares of any company or fund mentioned in this article.