Junk Funds, Up 33% This Year, Snag Billions

BOSTON ( TheStreet) -- High-yield bond funds have soared 33% so far this year, prompting investors to deposit $14.6 billion.

If you're inclined to join the crowd, ponder the complicated track record of the funds, which hold securities that are below investment grade. Over the years, junk bonds haven't always generated big returns.

During the decade ending in June, the S&P 500 Index lost 2.2% annually, and the Barclays Capital Aggregate U.S. Bond Index gained 6%. Meanwhile, high-yield funds returned 2.9%, finishing about halfway between the stock and bond benchmarks. High-yield funds landed in the middle of the field during the market collapse of 2008 and in the rally of 2006.

Why does junk occupy a middle ground? During periods when the economy is improving, stocks may rise since investors believe that companies will be worth more. Investors also bid up junk-bond prices as the risk of default recedes. But junk doesn't usually increase as rapidly as stocks because bondholders are lenders, not shareholders who can enjoy the full benefits that occur when a business succeeds.

During downturns, junk falls less rapidly than stocks. The rich bond yields serve as a cushion, providing income to investors during periods when stocks are plummeting. While junk can help to stabilize a portfolio, investment-grade bonds offer the best protection, sometimes rising when stocks fall.

Why bother with junk bonds at all? By putting a bit of assets into junk, long-term investors can diversify portfolios. Those who don't want to hold junk over the long term may still find it appealing during the occasional periods when high-yield markets become deeply depressed. After such downturns end, junk often rockets up.

Though this year's junk rally was outsized, it wasn't unique. After collapsing during the savings-and-loan crisis, junk funds returned 37% in 1991. In 2003, they recovered from the tech downturn and gained 24%.

To benefit from the ups and downs in the high-yield markets, consider strategic income funds. These typically hold a mix of three fixed-income sectors: junk bonds, investment-grade U.S. issues and foreign bonds. Portfolio managers are free to shift between sectors, focusing on the most attractive securities. The funds offer an intriguing way to emphasize junk when it's depressed.

A top choice is Fidelity Strategic Income Fund ( FSICX), which has returned 7.5% annually during the past decade. When the Fidelity managers see no screaming bargains and are neutral on the markets, they keep 55% of assets in high-yield bonds and risky issues from the emerging markets, with the rest in investment-grade securities. As markets collapsed last fall, the fund turned conservative, holding only 40% of assets in junk and risky securities. "That was a much more conservative position than the fund has typically taken," fund manager Joanna Bewick says.

Since then, the fund has turned more aggressive, putting 56% of assets in junk and risky securities. Even after the rally, junk bonds could still deliver decent returns, Bewick says.

On average, junk bonds yield about 500 basis points (100 basis points is equal to a percentage point) more than 10-year Treasuries, the Fidelity manager says. As the crisis worsened last fall, bond prices fell and yields skyrocketed. The spreads over Treasuries exceeded 1,500 basis points as investors demanded extra yield to compensate for risk. Since then, spreads have come down to around 900 basis points, as high-yield bonds yield about 12.5%. Bewick figures that the yields should compensate for any losses that occur because of defaults.

Another fund with a bet on junk is the Federated Strategic Income Fund ( STIAX), which has returned 6.4% annually during the past decade. When he's neutral on bond markets, fund manager Joseph Balestrino keeps 40% of assets in junk. Worried about mounting troubles, he had 32% of assets in high yield in early 2008. Then, as bonds began collapsing in the fourth quarter, he started scooping up cheap securities and now has 46% in junk. "Valuations are still compelling, and most of the worst economic problems are now behind us," Balestrino says.

Balestrino says the risk of defaults will soon decline. In recent months, the share of junk issues defaulting has climbed sharply, rising from an annual rate of 2.7% in July 2008 to 11.5% this July, according to Moody's. Now Moody's forecasts that defaults will peak at 12.7% in the fourth quarter. That's high, but Balestrino says bond prices already reflect the danger.

To own a more cautious stake in high-yield bonds, consider Franklin Strategic Income ( FRSTX). While the fund can have up to 40% of assets in below investment grade securities, manager Eric Takaha currently has about 32% in that category. "Valuations are still somewhat attractive, but it is unlikely that high-yield bonds will do as well in the next six months as they did in the last six months," Takaha says.

To limit risk, Takaha has sizable stakes in Treasuries and investment-grade corporate bonds. By staying diversified, Takaha aims to deliver steady yields and solid total returns. Most often the fund has succeeded. Franklin currently yields 7.7%. During the past 10 years, Franklin returned 6.5% annually.

Another relatively cautious choice is Thornburg Strategic Income ( TSIAX), which has about 30% of assets in bonds that are rated below investment grade. With the economy still shaky, the portfolio managers are focusing on bonds from solid companies, such as Caterpillar ( CAT). "A few months ago, bond prices were so low that there were lots of things to buy," manager Jason Brady says. "Now you have to be very selective and only buy companies with reasonable prices and very good balance sheets."
Stan Luxenberg is a freelance writer who specializes in mutual funds and investing. He was formerly executive editor of Individual Investor magazine.

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