NEW YORK (TheStreet) -- Billionaire investor Carl Icahn's warning about the risks of junk-rated debt might scare you, but that doesn't mean you should write off the entire category.
He sounded the alarm about high-yield -- or non-investment grade -- securities last week, saying the market is "extremely overheated." It's not the first time that observation has been made.
Still, there is a case for you to keep at least a portion of your portfolio in this type of debt even though it's riskier. Specifically, you might want to consider the SPDR Barclays High Yield Bond (JNK - Get Report) or the iShares iBoxx $ High Yield Corporate Bond (HYG - Get Report) exchange-traded funds. Here's why:
1. -- If You Like Stocks, You Should Love Junk. I hear plenty of people who should know better say that junk-rated debt is just too risky. But these same people go out and invest in stocks, which are risky but have high returns over time.
That attitude just doesn't make sense. If you like stocks, you should love high-yield securities. They're like stocks in drag.
The returns for these lower-rated securities are highly correlated with those of the stock market. As the stock market rallies, you can expect the high-yield returns to rise too. The returns are also less volatile than those of stocks. I've talked to lots of strategists about this, and I've seen a variety of analyses. A general rule is that junk debt should give you two-thirds of the returns of the stock market, but with half the volatility. That's over the long term.
2. -- The Spreads Are Higher Than They Were In 2004. The extra yield investors receive over those provided by risk-free government bonds (the so-called spread) is not low in comparison with historical levels. In fact, spreads are now a little higher than they were before the heady days of the housing boom.
In January 2004, the junk-debt spread was 4.05 percentage points. Now, it's 4.66 percentage points. Both figures are from the St. Louis Federal Reserve's FRED database.
3. -- Shaky Companies Benefit More From a Stronger Economy. As the economy grows better, less robust companies benefit disproportionately.
4. -- The ETF Expenses Are Low And The Market For Them is Liquid. The SPDR has annual expenses of 0.4%, and the iShares has costs of 0.5% a year. The average expenses for specialty high-yield mutual funds are 1.08%, according to Morningstar. Average daily volume for both ETFs is in the millions of shares.
So there's the case for high yield, but there are potential problems, too.
First, the sub-prime lending crisis showed the vulnerability of credit markets. If we have learned anything in finance in the past decade, it's that the credit markets can crumble. Indeed, that was the central issue in the sub-prime crisis and the ensuing Great Recession.
If the credit markets freeze again, even partially, it will be the high-yield sector that will feel it first and most. It won't be pretty. For that reason, you should consider a small allocation to junk securities, not a large one. Most investors wouldn't want to hold more than a third of their fixed-income allocation in junk and probably less.
Second, the ETFs follow indexes. Both the SPDR and the iShares invest primarily in securities listed in high-yield indexes. That tends to mean that the prices of the bonds in those indexes are bid up a little. Higher prices mean lower returns. That's bad, but in addition, because of the indexing, debt that is deteriorating will stay in the fund.
Active mutual fund managers can and do invest where they see opportunities inside and outside the indexed group of securities (including ditching the basket cases). A couple of funds worth considering are the Columbia High Yield Bond (RSHIX) and the Ivy High Income (IVHIX). Both have five-star ratings from Morningstar and below-average expenses for specialty high-yield mutual funds.