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Junk-Bond Bargains Await the Brave

TheStreet.com - Oct. 13, 2008 by Peter McDougall

The past few weeks have been scary for almost every type of investment other than Treasury bonds. High-yield bonds, also known as junk bonds, have been hit especially hard: The average high-yield bond fund lost more than 15% during the 30 days through Oct. 9, according to Morningstar.

If you like looking for bargains among downtrodden investments, you might be considering increasing your stake in this high-octane segment of the bond market. Indeed, junk bonds now offer some of the lowest prices and highest yields they ever have, relative to Treasury bonds. Trouble is, junk bonds remain enormously risky.

First, some background. High-yield bonds are issued by companies with relatively weak finances. (Those with credit ratings of BB or lower, as rated by Standard & Poor's.) A shaky balance sheet increases the chances that a company will be unable to meet interest and principal payments on its bonds, and will be forced to default -- hence the securities' trashy nickname. As a result, financially weak borrowers have to offer high interest on their bonds to attract investors.

A small allocation to junk bonds can play a valuable role in a diversified portfolio. The securities' high interest payments can boost the income your portfolio throws off. What's more, high-yield bonds have the potential for strong returns: The average high-yield bond fund gained more than 24% in 2003, according to Morningstar.

But junk bonds carry risks that are commensurate with their potential rewards. Economic downturns increase the odds that weak companies will default on their debts, typically causing investors to sell off high-yield bonds rapidly, as they have in the past month. Selling pushes the bonds' prices down and drives their yields up.

Investors worried about the global economic and credit crises recently have run screaming from high-yield bonds. Meanwhile, they've rushed into the safety of Treasury bonds. As a result, junk bonds this week offered yields more than 12 percentage points higher than Treasuries -- the largest yield "spread" since people started keeping track in the mid-'80s.

Buying high-yield bonds when spreads reached double digits has paid off in the past. Spreads neared today's levels in fall 2002, just before junk bonds enjoyed a four-year rally. They also passed 10 percentage points in 1991, and high-yield bonds surged during the next three years.

This time may be different. The size of today's crisis dwarfs the economic problems of 1991 and 2002, and probably will take much longer to fix -- so spreads may widen even further before high-yield bonds start to recover.

That said, income-seeking investors may want to investigate a small stake in a high-yield bond fund. Even a small allocation to a fund can significantly boost your portfolio's income -- especially since Treasuries currently offer yields in the low single digits.

Funds are a better choice than individual high-yield bonds, because they provide diversification that can mitigate the effects of defaults, as well as professional management -- essential given the bond market's complexities and minute-by-minute changes.

Given the current environment, it makes sense to stick to funds that take a relatively conservative approach to the junk sector. Fidelity High Income(SPHIX Quote - Cramer on SPHIX - Stock Picks) is a good option. Manager Fred Hoff focuses on the higher-quality end of the high-yield spectrum, and has consistently outperformed his peers. T. Rowe Price High-Yield(PRHYX Quote -Cramer on PRHYX - Stock Picks) also avoids the market's riskiest bonds. It has fared well in rough markets, outperforming almost 90% of its rivals during 2002 and more than two-thirds of the high-yield group during the month through Oct. 8., according to Morningstar.

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