Junk Bonds' Strength Belies Balance Sheets

Christopher Garman, head of high-yield strategy at Merrill Lynch, agrees. "If an investor is worried about the interest rate cycle and doesn't want bonds yet isn't enthusiastic about the stock market, high yield is a great intermediate place to be, and it has diversification benefits over time," he said.

High-yield bonds are not highly correlated to stocks and are even less correlated to government bonds.

Although economic growth could be slowing down, Fridson said GDP will probably remain above 1.5% to 2% going forward. "That's important, because below those levels, default rates start to increase," he said. The economy grew 2.8% in the second quarter after a 4.1% increase in the first.

Greg Hopper, portfolio manager of the Julius Baer Global High-Yield Bond Fund, said sluggish economic growth is "not a formula for equity outperformance" and suggested that the best returns this year will probably come from junk bonds. The high-yield sector should produce total returns of 7% to 8%, he said.

In addition, Hopper and other analysts note that junk bonds are more insulated from rising interest rates than stocks and Treasuries. When the Fed embarked on an aggressive tightening campaign in 1994, high-yield bonds escaped almost unscathed, performing better than government bonds and the S&P 500.

"Bonds that are shorter in maturity, higher in yield and have higher coupons just have less interest rate sensitivity," said Fridson.

Wesley A. Sparks, first vice president at Schroders Investment Management, recommends that investors get exposure to a global high-yield fund, not just U.S. high yield, "because there are many attractive investment opportunities in the small but growing European and Asian high-yield markets."

Still, he noted that investors should only allocate about 10% of their total assets to high yield and warned that these bonds can exhibit volatile returns. "The high-yield asset class [is] appropriate only for investors with reasonable risk tolerance," he said.

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