NEW YORK (TheStreet) -- Since the financial crisis, nervous investors have been pouring into bond funds. But the flight to fixed income could produce dismal results. The problem is that most bond funds drop when interest rates rise, and many economists expect that rates will climb in coming years.Investors recently got a taste of how hazardous rising rates can be. During the past month, rates on 10-year Treasuries climbed 0.30 of a percentage point to 2.28%, and long government funds lost 2.8%, according to Morningstar. For protection, investors should diversify portfolios. One strategy is to add high-yield funds, which invest in junk or corporate bonds that are rated below-investment grade. High-yield funds showed their resilience in the past month, returning 1.0% and outpacing most bond categories. The strong showing was not unusual. Junk bonds often climb as the outlook for the economy improves and the risk of defaults declines. Can high-yield funds continue rallying? Yes, argues Tom O'Reilly, portfolio manager of Neuberger Berman High Income Bond ( NHINX). O'Reilly says that the bonds are currently undervalued because investors remain wary about defaults. The default rate peaked in 2009 when 10% of junk bonds collapsed. Now most of the shakiest bonds have been eliminated. The survivors have been strengthening their balance sheets and refinancing debt. The ratings agencies have been upgrading many issues. With the economy improving last year, only 1.8% of junk bonds defaulted, a rate that is below historical averages. O'Reilly figures that the default rate this year will be 1.5%. Despite the healthy performance, investors are pricing bonds as if they will suffer a default rate of 6%, he says. As the year progresses, investors will become less nervous and bid up prices to account for the modest default rate. That should enable the funds to return 8% to 12% for the year, O'Reilly says. Most of the return of junk bonds this year should come from their relatively rich yields. The bonds yield 6% to 8%, a fat payout at a time when money-market funds yield next to nothing.
Yield-starved investors have taken note. During the past year, investors put $18.9 billion into high-yield funds, a big inflow for a category that only has $220 billion in total assets, according to Morningstar. Make no mistake, high-yield bonds come with more risk than investment-grade issues. During the downturn of 2008, high-yield funds lost 26.4%, while intermediate bond funds -- which focus on investment grade securities -- dropped 4.7%. But over long periods, the extra risk of junk bonds has been worthwhile. During the past decade, high-yield funds returned 7.6% annually, outdoing intermediate-term funds by more than 2 percentage points. Although they are riskier than intermediate bonds, junk securities are less volatile than stocks. So high-yield funds can make sensible additions for investors who are wary of suffering big stock-market losses, says Kevin Loome, portfolio manager of Delaware High-Yield Opportunities ( DHOAX). High-yield bonds outdid stocks by a wide margin in 2008 and during the downturn that occurred after the Internet bubble burst in 2000. "High-yield can be a good choice for people who want decent returns but can't accept the risk of equities," Loome says. For a relatively cautious fund, consider TIAA-CREF High-Yield ( TIYRX), which returned 7.7% annually during the past five years and outdid 92% of peers. The fund emphasizes the higher-quality names in the junk universe. TIAA-CREF has 51% of its assets in bonds rated BB, the top rating for high-yield bonds. In contrast, the average fund in the category only has 28% in BB. Although TIAA-CREF has 3% of assets in bonds rated less than B -- near the bottom of the credit rankings -- the average fund has 14% of assets in the lowest category. The higher quality helped TIAA-CREF excel during the downturn of 2008. For the year, the fund outdid 88% of peers. Another relatively tame choice is Vanguard High-Yield Corporate ( VWEHX). The fund returned 6.5% annually during the past five years, outdoing 62% of peers. Vanguard has 50% of its assets in BB bonds and 6% in bonds that are rated BBB, the lowest investment-grade ranking. The fund often lags competitors in rallies, but it outperforms in hard times.