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High-Yield Bonds, After Rally, Keep Appeal

NEW YORK ( TheStreet) -- After suffering crushing losses in 2008, high-yield mutual funds have rebounded sharply.

Last year, the funds returned 47%, and this year they have tacked on another 5.5%, according to Morningstar. After the record rally, are high-yield bonds still appealing? Yes, says Joe Balestrino, manager of Federated Strategic Income (STIAX). "The fundamentals for the high-yield market are sound, and the valuations are still fairly cheap," he says.

High-yield bonds are rated below-investment grade. Because of their extra risk, the bonds yield more than investment-grade securities. When the markets froze in 2008, high-yield bonds yielded 20 percentage points more than Treasuries as panicked investors demanded steep yields to compensate for what seemed to be enormous risks of defaults. Since then, markets have calmed. Now the bonds yield about 7 percentage points more than Treasuries. That is well above the historic average spread of 5 percentage points.

The spread is still high because investors are nervous and fear the default rate will spike above the historic average annual rate of 4%. But the current default rate is only about 2%. If conditions persist, investors will collect double-digit yields on their bond portfolios and suffer only minor losses from defaults.

Balestrino of Federated argues that default rates will remain muted for some time. He says shaky companies already defaulted during the recession and those that survived the downturn are in sound shape. With the economy growing slowly, most high-yield companies should have enough cash to maintain their interest payments. "The marketplace cleansed itself during the recession," Balestrino says.

Federated Strategic Income holds a mix of securities that includes foreign bonds, government isssues and high-yield bonds. During the past five years, the fund has returned 6.9% annually, outdoing 86% of its peers in the multisector bond category, according to Morningstar.

When Balestrino is in his neutral position, he has 40% of assets in high yield. Because he is bullish these days, the fund has 48% of assets in high yield.

For a tame way to own high-yield bonds, consider Intrepid Capital (ICMBX), a balanced fund that keeps about 20% of assets in high-yield bonds and the rest in cash and small-cap stocks. During the past five years, the fund returned 6.4% annually, outdoing 99% of its peers in the moderate allocation category, according to Morningstar.

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