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.

To hold down risk, manager Mark Travis focuses on bonds that have maturities of three years or less. Such short bonds have relatively low default rates. When interest rates rise, prices of long bonds can decline sharply, but short bonds are resilient.

Travis says a portfolio of high-yield bonds can produce double-digit returns over the long term. The rich yield helps to cushion the fund during downturns when stocks may plummet. "With high-yield bonds you can get equitylike returns without taking as much risk as equities," he says.

For security, he favors issuers that have enough cash flow to cover their interest expenses five times over. Holdings in the portfolio include bonds from Brinker International ( EAT), operator of the Chili's restaurant chain, and Phillips-Van Heusen ( PVH), which markets apparel under such well-known brand names as Calvin Klein and Izod.

Another cautious way to own high-yield bonds is FPA Crescent ( FPACX). Besides high-yield securities, manager Steven Romick owns a wide mix of stocks, bonds and convertibles. When he is wary, Romick holds big stakes of cash. Most often, his moves have been on target. During the past five years, the fund has returned 5.2% annually, beating 98% of its moderate allocation peers.

As markets crashed in 2008, Romick shopped for bargains, putting 30% of his assets in high-yield bonds. He bought many bonds at a 30% discount to their par values. Since then, his holdings have rallied, and now many sell at par. With prices back to normal levels, Romick has trimmed his high-yield stake, which now accounts for 19% of the fund's assets. A die-hard value investor, Romick is holding his high-yield bonds because he can't find anything else to buy. Most stocks and bonds are too rich, he says. Many of his high-yield bonds now yield 8%. That's attractive at a time when money markets yield almost nothing.

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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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