Five Funds: Good Bets for Junk Bond Funds

Editor's note: This is the first installment of a weekly series, Five Funds, which offers solid mutual fund picks in a specific category. This week's focus: high-yield bond funds.

After a few years in the doldrums, junk bonds during the past three months lived up to their more sanguine moniker: high-yield.

The average high-yield bond fund has returned an impressive 9.6% during the past three months, according to Morningstar. While that torrid pace (this is the bond world, folks) is likely to ease a bit in 2003, fixed-income strategists and money managers -- including skippers at Pimco, T. Rowe Price and Oppenheimer -- have recently sung the praises of the junk bond market, saying it looks like the strongest component of the cooling fixed-income arena. And so it goes, cash has poured in to the sector: High-yield corporate bond funds reported $1.0 billion in inflows for the week ended Wednesday, the largest level since Nov. 6, according to AMG Data Services.

With more money likely to flow into the category, we thought it appropriate to kick off our Five Funds series with stellar offerings from the junk bond fund world.

But first, a quick background and a few kernels of advice on the junk bonds and junk bond funds. Corporate junk bonds are below investment-grade bonds as rated by agencies like Standard & Poor's and Moody's (below BBB- and Baa3, respectively). The downside with junk bonds is the risk of default -- last year witnessed a record $170 billion in junk bond defaults, according to Moody's, which projects the default rate will ease 7% this year.

With Funds, What You Don't Know Can Cost You Here's how to see how much you're paying for your mutual funds, and how to cut costs.

G. Paul Matthews Sees Riches in Asian Funds The skipper is betting on Asia's technology sector and continued strength of select Asian markets.

In exchange for the risk of investing in troubled or speculative companies in the junk bond arena, investors get the potential for greater rewards in the form of higher rates of return. Junk bond woes recently pushed the spread between junk bonds and Treasuries to north of 1,000 basis points, or 10 percentage points. In other words, junk bonds might pay 10% more than the benchmark 10-year Treasury's 4%.

"Even with the recent runup, there are better opportunities here, given the yield spreads," said Scott Berry, bond fund analyst at Morningstar.

Since investing in individual bonds often requires a minimum of $5,000 or more, the easiest way for individuals to tap into the market is junk bond funds. "Unless you have in excess of $100 million, you should get into junk bonds via a fund," says Harold Evensky, a financial planner and principal with Evensky Brown & Katz in Coral Gables, Fla.

These funds offer diversity -- you wouldn't have wanted to own only WorldCom junk. Given that they are somewhat of a specialty asset class and carry additional risks if the economic recovery falters, Evensky and other financial planners suggest investors who want to buy into junk bond funds should keep them to about 5% to 10% of their total portfolio.