Credit Junkies
Sure, the credit markets look better, but investors are too optimistic about high yield.

For someone who buys junk for a living, Michael Difley looks awfully picky.

Difley, who manages the American Century High-Yield Fund, bought bonds from office supplier Staples earlier this year when credit markets still looked dangerous. By the end of March, Staples' investment-grade bonds had become one of his fund's largest holdings.

Since then, cash has poured into bond funds like his, enabling companies to borrow and lifting the market -- especially bonds from companies with the weakest balance sheets. Has the high-yield rally gone too far? Probably, Difley says, because an economic recovery is going to take longer than many expect. Throughout the rally, he avoided the riskiest of junk paper but he’s now sold off hisStaples ( SPLS - news - people )’ bonds and is avoiding retailers. Nearly 20% of his fund is less-risky, investment-grade paper, according to recent filings.

"The greatest risk is that people are going to be disappointed on the strength of the recovery," he says. Don’t count on the deeply indebted and increasingly out of work American consumer to borrow even more and boost growth. People will save more and spend less, which means tepid growth at best. "Not that good for credit," he says. And bad news for retailers and companies with large debt loads.

Playing cautiously in this market has weighed on the fund’s relative performance. His nominally high-yield portfolio hasn’t kept pace with the rapidly rising high-yield market. Its 13.7% gain this year beats the 12.4% turned in by the Barclay’s Capital Aggregate Bond Total Return Index, but fares worse than the 28% for the high-yield bond market. Over time, however, Difley expects his more cautious approach to win out as the weaker companies fall into bankruptcy and their bondholders suffer.

As a group, bonds used by private equity firms to buy companies are widely considered some of the most likely to default. Difley still owns some bonds used in these leveraged buyouts, including paper issued by Sungard Data Systems, Texas utility Energy Future Holdings and hospital chain HCA. "All LBOs are not created the same," he says. Larger companies, such as HCA, with more stable cash flow are better able to shoulder larger debt burdens.

HCA is one of the fund’s largest holdings. Other large stakes include bonds from DaVita ( DVA - news- people ), PetroHawk Energy and Cinemark. Difley’s fund sports a four-star rating from Morningstar and charges nothing up front. Its management fee is 0.8%.