Junk Bonds Aren't Trash

05/15/2008 12:00 am EST

Focus: BONDS

Tim Middleton, contributor to MSN Money, says high-yield bonds, which plunged during the credit crisis, are rebounding with the markets—and he recommends some good funds.

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 6th—a better performance than small-company stock funds, according to Morningstar. Yields are already falling as bond prices 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 [high-yield] funds. That's a huge, but shrinking, 6.5-percentage-point advantage over government bonds.

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.

Yields can fall as low as two percentage points over Treasurys in fat times and soar as high as 12 points over when defaults are accelerating. Thanks to years of strong economic growth, the US 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. [Junk-bond yields are] going down right now, because the risk of a really high default rate, as in 10%, is diminishing.

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. Despite their name, junk bonds are less risky than stocks because they have a much higher claim on a company's assets.

Excellent junk-bond mutual funds are abundant. Nearly every mutual-fund complex offers a good one. Among the names I can recommend are [the previously mentioned Julius Baer fund, which has 40% of its assets overseas], T. Rowe Price High Yield (PRHYX), Pimco High Yield D (PHYDX), and Loomis Sayles High Income A (NEFHX).

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.

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