Hefty returns from junk bonds

By Tim Middleton

Investors in corporate junk bonds are being paid handsomely to wait out the bear market in stocks.

That's because the companies issuing these bonds need cash, and the market smells risk in that need. For investors, risk means higher yields. Ten-year Treasury bonds are yielding around 2.5%; junk of similar maturity yields as much as 20%.

That's plain stupid. Yields that high have driven the price of junk bonds to historic lows, making them bargains. Yet the risks are overstated. With bond funds, moreover, you can diversify enough to reduce your risks even further.

But it has made junk bonds, a traditional stalwart in income-oriented portfolios, attractive now to stock investors as well. In the current climate, this is one of the few corners of the investment universe offering double-digit returns.

A rally gets rolling

About two months ago, I pointed out that investment-grade corporate debt was wildly cheap and ripe for a rise. Since that article appeared, the iShares iBoxx $ Investment Grade Corporate Bond Fund (LQD, news, msgs), an exchange-traded fund, had rallied 12%, as of Jan. 7. That's more than twice as much as the Standard & Poor's 500 Index ($INX), ahead 5.5% in the same period.

• For more on bonds, watch the videos to the right.

Now that credit markets have settled down even more, below-investment-grade (or junk) bonds are showing the same kind of resilience. In fact, they're surging. The iShares iBoxx $ High Yield Corporate Bond (HYG, news, msgs) ETF rose 22.8% in the past month, though it was still down 12.6% over the past 12 months.

"Some junk bonds are trading as much as 20 percentage points above the 10-year Treasury," says Edward Yardeni, an independent economist and market strategist. Something around 4 points would be more normal. "Yields are high enough that (junk-bond funds) should absorb whatever defaults occur and still leave you with a pretty good return," Yardeni says.

Fear of default -- that a company will go broke or otherwise be unable to make good on its debts -- is what drives up the return on junk bonds. And you should be paid more for lending the issuers this money. But with funds, you reduce the risks associated with individual junk bonds by owning a basket of them.

Fueling the surge

The average spread, or premium, of junk-bond yields over more-secure Treasurys peaked at 17.7 percentage points Dec. 12, according to the Merrill Lynch High Yield 100 Index. By Jan. 7, that spread had contracted to 10.7 points. One trigger for the rally in junk was the settling back of the London Interbank Offered Rate, or Libor.

Unlike the Federal Reserve's federal funds rate and other rates set by central banks, the Libor is a free-market indicator of what banks charge each other for overnight loans. At the peak of the credit crunch late last year, the Libor topped 6%. In the week after Christmas, it sank as low as 1.45% -- evidence of trust in financial stability.

There are dozens of excellent junk-bond mutual funds and another top exchange-traded fund, SPDR Barclays High Yield Bond (JNK, news, msgs), formerly the SPDR Lehman High Yield Bond ETF.

On New Year's Eve, I advised subscribers to my newsletter, ETF Insider (subscription required), to buy positions in the junk-bond spider. It tracks the Barclays High Yield Index, the industry standard. The iShares fund, meanwhile, tracks a proprietary index of slightly higher-quality bonds. My rationale for targeting the broader market is that lower-quality junk will benefit more from a stronger credit market than the best stuff, which hasn't been beaten down as much.

Mutual fund investors, though, may make their choices for different reasons. ETFs are excellent trading vehicles as well as long-term investments because there are no rules against selling them for short-term gain. Many mutual funds, on the other hand, impose heavy fees on quick trades, making them less attractive for short-term players.

So if you want to buy a junk-bond mutual fund basically to wait out the bear market, and dump it when things settle down, your choice could be different than if you want to buy it and hold on for the long term.

Continued: The play for right now

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