3 High-Yield Funds Rekindling the Flame

NEW YORK (TheStreet) -- Fleeing risky assets, investors have been selling high-yield bonds, which are rated below-investment grade. High-yield funds have dropped 3.8% in the past month, according to Morningstar. In August, investors withdrew $4.2 billion from high-yield funds, according to Lipper.

But after the recent declines, the bonds look intriguing. High-yield securities currently yield 8.8%, an attractive level at a time when money markets pay virtually nothing and five-year Treasuries yield 0.90%. By adding a small dose of high-yield bonds, you can diversify a bond portfolio and possibly boost returns.

To evaluate high-yield bonds, many portfolio managers compare them to Treasuries. During the past 25 years, high-yield bonds on average have yielded 450 basis points (4.5 percentage points) more than comparable Treasuries. For much of the first five months of this year, the spread stayed near the average, bouncing between 450 and 475 basis points.

Then starting in June, the markets became concerned that the economy could slip back into recession. For safety, investors sold high-yield bonds and bought Treasuries. When bond prices fall, yields rise. As yields on junk bonds topped 8%, the spread over Treasuries increased to 550 basis points in July. In August, the panic selling continued and the spread topped 730 basis points.

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In the past, it often paid to buy high-yield bonds after the spreads widened sharply. A great buying opportunity occurred in the late 1980s when many bonds defaulted and the spread widened to 1,000 basis points. In 1990, high-yield funds lost 10.2%, but then they bounced back, gaining 36.5% in 1991. The record downturn happened during the financial crisis in 2008 when the funds lost 27.1%, and the spreads reached 1800 basis points. In 2009, high-yield funds roared back, returning 45.7%.

While yields are lower now than they were during the financial crisis, portfolio managers argue that current conditions are much steadier. During the financial crisis, earnings of many issuers collapsed and default rates surged. But these days corporate earnings are solid, and default rates are small. Many high-yield issuers have paid down their debts and are hoarding cash.

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