Are You Too Late for the Junk-Bond Party?

By JASON ZWEIG Christopher Serra Every once in a while, people don't just invest in an asset; they swarm it. That's what has been happening to junk bonds. Goaded by the monstrous returns on junk—53% this year—and the miserable yields on cash, investors have put well over $20 billion into high-yield bond funds in 2009. "The inflow of funds has been phenomenal," says Daniel Fuss, manager of the $18.5 billion Loomis Sayles Bond Fund. "I have not seen a rally like this, ever, in the high-yield market." Mr. Fuss bought his first junk bonds more than 40 years ago. As they so often do, investors are piling in even as the party may be starting to wind down. There have been plenty of reasons to party. A year ago, in the depths of the financial crisis, the bonds of below-investment-grade companies traded at an average of only 61 cents on the dollar, about as cheap as they have ever been. At last fall's depressed prices, junk bonds out-yielded Treasury securities by a staggering 19.9 percentage points. Today, prices have recovered to roughly 92 cents on the dollar and the premium, or spread, above Treasurys has shrunk to 7.6 points, according to Bank of America Merrill Lynch. The long-term average spread is 5.6, suggesting that the yields on junk bonds could fall another two percentage points or so. Bond yields fall as prices rise, adding to total return. Christopher Garman of Garman Research estimates that narrowing spreads could contribute to a total return of roughly 13% to 15% over the next year. Still, concedes Mr. Garman, high yield is "no longer the capital-appreciation vehicle it was" a year ago. And if the economy doesn't rebound, more borrowers will end up defaulting on their junk bonds. Mr. Garman's return projections assume a 5% default rate, not much above the long-term average. Right now, the default rate is running about 12%; if it doesn't decline, returns will suffer. Considering its risk, junk's average returns over recent years have been a mixed bag. Steven Huber, manager of T. Rowe Price Strategic Income fund, points out that when you include their 26% loss in 2008, junk bonds have returned an annual average of just under 6% since the beginning of last year — the same as top-quality corporate bonds and only a whisker more than Treasurys. Extend the comparison back a full decade and the results are the same: The returns on high-yield bonds have been no higher than those of safer bonds. Of course, the same could be said for stocks. "With hindsight, it's hard to justify having taken any risk over the past 10 years, since it didn't pay off," says Martin Fridson of Fridson Investment Advisors. "Over the long term, you do get paid to take risk. It's a question of how long the long term is for you." Baylor University finance professor William Reichenstein says that junk-bond returns are highly similar to what you would get if you put two-thirds of the money in investment-grade bonds and one-sixth each in large-company stocks and small-company stocks—all of which you probably own already. "Who needs junk bonds to have a diversified portfolio?" asks Prof. Reichenstein. "I would say nobody. They're a hybrid asset, neither fish nor fowl. They muddy your asset allocation without adding a lot of diversification." Junk bonds do diversify against the risk of rising rates. Because of their fatter current income, junk bonds should lose less than Treasurys and other high-quality bonds if the Federal Reserve jacks up rates. Mr. Fridson notes that the last three times interest rates rose by at least one percentage point, high-yield bonds outperformed Treasurys by up to 13.8 percentage points. So a junk-bond fund might be for you if: you think the economy will continue to recover slowly from recession; if you live off your investment income and you want protection against the risk of rising interest rates; if you can find one that charges well below the average annual cost of 1.2%; if you aren't already loaded up with small stocks and if you can put the junk-bond fund in a retirement account where the interest will be sheltered from income tax. That's a lot of ifs. For most investors, the junk-bond party is already just about over. If you missed the happy hour, there's not much point diving in after the good times have already rolled. Write to Jason Zweig at intelligentinvestor@wsj.com