The Case for Junk Bonds

The time to pounce on any beaten-down investment is when the news is still lousy but no longer terrifying. That explains why investors are now fighting over foreclosed houses. The same rule applies to corporate high-yield debt, so it's time to start wading into junk bonds.

Here's why I think the worst is over for junk: In early February, Chesapeake Energy, a debt-laden natural-gas producer based in Oklahoma City, decided to issue $500 million worth of bonds to repay bank loans that were coming due.

Successful offering. Chesapeake is the kind of enterprise that as late as November had no hope of selling bonds at any price. Yet on February 2, Chesapeake not only brought a debt offering to market but also managed to sell $1 billion worth of bondsÑtwice what it had originally proposed. The bonds yield 10.6% to maturity in six years. That seems fair, given the company's problems and its junk ratings: BB from Standard & Poor's and Ba3 from Moody's.

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The bonds aren't backed by any of Chesapeake's assets, so they may seem dicey. But 10.6% is more than eight percentage points higher than the yield of Treasury securities with a comparable maturity, and it's five percentage points more than what you can get from a decent-quality, six-year bond, such as an A-rated issue from Metropolitan Life.

Managers of junk-bond mutual funds are thrilled to see established but low-rated companies, such as Chesapeake, DirecTV and El Paso Corp., issue debt once again. For most of 2008, few junk bonds came to marketÑand there were almost no buyers. Fund managers had to sell buckets of bonds, often to one another, to meet unrelenting investor redemptions.

The turning point came in December. That's when the government rescued Chrysler, General Motors and GMAC, all leading issuers of high-yield bonds. "That seemed to lift the animal spirits" of investors, says Sabur Moini, a 15-year junk-bond veteran who manages Payden High Income fund. Fresh money rediscovered junk funds, and low-quality bonds rallied. Between December 12 and January 28, SPDR Barclays Capital High Yield Bond (symbol JNK), an exchange-traded fund that tracks the junk-bond market, appreciated 22%.

Although junk bonds subsequently surrendered some of their gains, the December-January run-up looks as if it's more than a short-term bounce. Whether it is or not, don't underestimate the risks, the most obvious being the likelihood of a flurry of defaults. Both S&P and Moody's forecast that the default rate for junk-bond issuers will more than double in 2009, to more than 10%. But even this scary statistic may not be as frightening as it first seems. A disproportionate number of insolvencies will be in retailing, home building and auto parts. Most intelligent fund managers know this and have already shed bonds from these sectors.

You may wonder about the conventional wisdom that junk tracks the stock market more than it follows other kinds of bonds. That's true, to some extent. But it's also important to remember that as risky as high-yield bonds may seem -- especially in a severe recession -- they're not nearly as dangerous as stocks. Last year, junk lost 26% on average, while every segment of the U.S. stock market lost more.

For most individuals, funds are the best way to invest in junk. To avoid climbing too far up the risk ladder, look for portfolios that yield 10% or so rather than 12% or more. You can choose from among three ETFs, including the SPDR mentioned earlier, plus dozens of open-end funds. Among smaller no-load funds, I like Payden High Income (PYHRX), Metropolitan West High Yield Bond (MWHYX) and SSgA High Yield Bond (SSHYX). If you prefer dealing with the big players, you'll be able to ride junk's recovery with Fidelity High Income (SPHIX), T. Rowe Price High-Yield (PRHYX) and Vanguard High-Yield Corporate (VWEHX).