The 8 percent solution? Investing in junk (bonds) is risky but could pay off in weak market

Junk bonds: Savvy investment or fool’s gold?

CHICAGO — A sideways stock market has investors searching for other places to make a decent return on their money. And junk bonds, for better or worse, are starting to look like gems to many.

The appeal is easy to understand.

Junk bonds, known more politely as high-yield bonds, are bonds with very low credit ratings that corporations pay more interest on so they can attract investors. As of last week, they were yielding 8.34 percent, down from 9 percent earlier in July.

That number is mighty enticing at a time when the Standard & Poor’s 500 index is up just 1 percent for 2010 and down 22 percent from a decade ago. And a murky economic outlook hampers prospects of a strong rebound any time soon.

Virtually nowhere else can you get 8 percent back on your money these days. The going rate for a 10-year U.S. Treasury note last week was 3.05 percent, low by historical standards. It’s not much better for investment-grade, or more highly rated, corporate bonds: 3.8 percent, as measured by the Barclay’s Capital U.S. Credit Bond Index.

Return-starved investors have noticed. High-yield mutual funds have seen nearly $3 billion in inflows over the past three weeks, according to Lipper FMI, a unit of Thomson Reuters.

But investor beware: They’re called junk for a reason. Bonds below investment grade, or those with S&P ratings below BBB and Moody’s ratings below Baa, are much likelier to default.

Not only that, junk bonds act more like stocks than other bonds do. That’s because their prices are closely tied to the corporations that issue them and their ability to service debts.

So if you are considering adding them to your portfolio to diversify it, think again.

“Don’t expect a junk bond to hold its value if equities are doing poorly,” says John Donaldson, director of fixed income at Haverford Trust Co. in Radnor, Pa. “It will have good years when equities have good years and bad years when equities have bad years.”

High-yield bonds as a group lost about 35 percent in price in 2008 during the credit crisis, when stocks also tanked.

A casual investor may want to think more about the return OF capital than the return ON capital.

That doesn’t necessarily mean to steer clear of junk bonds entirely. There could be a place for them in your portfolio if you have a strong appetite for risk and a grasp of the pitfalls as well as the rewards.

“Junk bonds may provide an attractive income stream, as long as they are part of a diversified portfolio and the downside risks are clearly understood,” says Joseph Jennings, director of investments for PNC Wealth Management in Baltimore.

Here’s a look at some other points for investors to consider if they decide to chase those 8 percent yields:

— Stick with funds.

The average investor should not invest in individual junk bonds. There’s too big a risk of a default that can cost you a big chunk of money. A casual investor doesn’t have sufficient knowledge to assess them anyway.

A good mutual fund with a broad portfolio of junk bonds can generate enough extra income to offset any defaults.

— Investing in junk is speculating.

There’s nothing wrong with speculating. But if you do that, choose only an investment that you can afford to lose money on.

“There’s a reason why investors are offered such a ‘bounty’ relative to what they are earning on their CDs or savings accounts,” says Michael Kay, a certified financial planner based in Livingston, N.J. “An investor should always ask himself or herself, if a total loss is sustained, how will that affect their portfolio, their wealth and their lives?”

Risk of total loss, of course, should be minimal if you own bonds through a fund rather than individually.

— Experience and diversification really matter.

In researching a fund, pay extra attention to how long the portfolio manager has been there. Given the volatility of high-yield funds, you want a management team that has been tested by a variety of market conditions over the last five to 10 years and come through it with solid results.

Spreading your money out among different types of corporate junk also is extra important because of the risk that defaults in one weak sector could cost you heavily.

— Junk bond funds vary dramatically in credit quality.

Check the credit quality before you decide on your preferred level of risk.

“High-yield portfolios can vary in quality from ‘a little junky’ to ’stinky,’” says Dina Lee, a personal financial specialist with the American Institute of Certified Public Accountants.

A good way to invest in junk bonds is through a low-cost exchange-traded fund such as the iShares iBoxx $ High-Yield Corporate Bond Fund (HYG).

Alternatively, five high-yield funds recommended by Chicago-based Zacks Investment Research are Transamerica Partners High Yield Bond Fund (DVHYX), Federated High-Income Bond Fund (FHIIX), USAA High-Yield Opportunities Fund (USHYX), Catalyst/SMH High Income Fund (HIIFX) and John Hancock High Yield Fund (JIHDX).

Just don’t load up your portfolio with junk. Indulge with moderation, as with emerging-market stocks or with wine.