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.

"The fundamentals are great, and the default rate is still declining," says Gibson Smith, portfolio manager of Janus Flexible Bond ( JAFIX).

To own a limited stake of high-yield bonds, consider Janus Flexible Bond, an intermediate-term fund that holds a mix of government issues and investment-grade corporate bonds as well as high-yield securities. During the past 10 years, the fund has returned 6.5% annually, outdoing 90% of competitors. The fund adjusts its allocation, keeping from 3% to 25% of assets in high-yield bonds. Portfolio manager Gibson Smith currently has about 20% of assets in high-yield securities.

Some deft moves helped Smith sail through the financial crisis. To protect shareholders, he put most assets in Treasuries and lowered the high-yield allocation down to 8% of assets. The strategy enabled the fund to stay in the black during the downturn of 2008 and outdo 93% of peers for the year.

For a cautious high-yield fund, consider Aquila Three Peaks High Income ( ATPAX). Portfolio manager Sandy Rufenacht sticks with steadier issuers that are improving their balance sheets by paying down debt. He avoids cyclical companies, such as airlines and paper producers, which can struggle during recessions. The approach helped the fund beat its category average by 12 percentage points in 2008. The cautious strategy often lags in rallies when the market tends to favor riskier issues. During the rebound of 2009, Aquila trailed its average competitor by 20 percentage points.

Rufenacht likes bonds issued by Service Corp. International ( SCI), which operates cemeteries and funeral homes. "This is a solid business that can deliver consistent results in a recession," says Rufenacht.

He also likes bonds from Charter Communications ( CHTR), which provides cable television service. Even during recessions, subscribers tend to pay their cable bills, Rufenacht says.

A steady high-yield choice is Delaware High Yield Opportunities ( DHOAX), which has returned 8.6% annually during the past 10 years, outdoing 94% of competitors. Portfolio manager Kevin Loome varies the risk levels of the fund based on market conditions. As the financial crisis began to unfold in 2007, he overweighted bonds rated BB, the highest level of the high-yield universe. He shunned low-quality bonds with CCC ratings. These days he is bullish on the outlook for shakier assets and has 75% of assets in bonds that are rated B or lower.

"At this point of the market cycle, the economy is still growing, and lower-rated issuers should do well," he says.

Loome likes bonds issued by MGM Resorts International ( MGM), a casino operator. He says that the casino industry is recovering in Las Vegas. MGM also has a stake in Macau, a fast-growing gambling market.

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Stan Luxenberg is a freelance writer specializing in mutual funds and investing. He was executive editor of Individual Investor magazine.

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