Don't Buy This Junk

As welcome as 2009's rally has been, it's also left many investors and money managers feeling rather empty. Instead of being a broad-based, fundamentals-led recovery, the rally has been mostly focused on lower-quality securities and riskier asset classes. The stocks enjoying the greatest boost have been troubled, beaten-down names from last fall, such as financial players Wells Fargo (NYSE: WFC  ) , Bank of America (NYSE: BAC  ) , and Morgan Stanley (NYSE: MS  ) . After all, many of these stocks were knocked down so far, the only place they really had left to go was up! But investors should take care when fishing in these riskier waters, especially now.

Riding the junk bandwagon
The high-yield "junk" bond sector of the market has been on fire this year. For instance, one junk-bond ETF, the SPDR Barclays Capital High-Yield Bond ETF (NYSE: JNK  ) , is up 56% over the past year.

That's the kind of performance that we expect to see from stocks, not bonds! And as might be expected from performance-chasing investors, high-yield bond funds have been flooded with money this year, to the tune of more than $20 billion. Even junk bond managers have been caught off-guard at the volume of money flowing into their coffers.

But investors who expect the good times to keep on coming in this sector may be in for an unpleasant surprise. True, there's probably a little bit more room to run in this sector; according to The Wall Street Journal, the current spread between high-yield bonds and Treasuries remains about 2 percentage points above the long-term average, which suggests the potential for further price appreciation. However, this spread has fallen from an astonishing 20 percentage points last fall, which means that most of the profits have already been squeezed out of this sector.

Mixed messages
Although junk bonds are clearly fixed-income securities, they frequently behave more like equities. They offer the chance for greater rewards, and greater risk, than traditional bonds. As a result, it's not completely inappropriate to view high-yield bonds as an almost "hybrid" offering. Consider the recent performance of the SPDR S&P 500-tracking ETF and the tech-laden Nasdaq 100, compared to a high-yield bond index and a broad-market bond index:

Investment

2008 Return

2009 YTD Return

PowerShares QQQ (Nasdaq: QQQQ  )

(41.7%)

48.5%

SPDR (NYSE: SPY  )

(36.7%)

25.5%

SPDR Barclays Capital High Yield Bond

(24.7%)

32.0%

iShares Barclays Aggregate Bond Index (NYSE: AGG  )

7.9%

4.7%

Source: Morningstar. As of Dec. 1.

As you can see, high-yield bonds have performed more in line with equities than with their bond siblings. For most investors, bonds should not be viewed as a way to boost portfolio returns, but rather as a mechanism to dampen volatility and protect capital. Bonds are typically one place in your portfolio where you don't want to take on excessive risk.

But as the numbers bear out, junk bonds are risky! As a result, it may not be helpful -- or appropriate -- to lump a high-yield bond fund in with the rest of your fixed-income allocation. At the very least, realize that you won't get a lot of downside protection with junk bonds right now, and adjust your asset allocation accordingly.

Playing it smart
If you've been hungrily eyeing junk bond returns from afar, and you're thinking about getting in on the action, you should know that you're already late to the party. And if history has shown us anything, it's that investors that swamp a hot-performing asset class at the 11th hour usually end up getting burned. However, if you still want to dive into the junk bond world, make sure you do it carefully. As with other "non-vital" asset classes such as commodities or bear-market funds, keep your allocation to junk bonds very low. More conservative investors should probably skip this sector altogether.

When it comes to high-yield investing, you'll probably want to rely on the expertise of someone with an extensive high-yield background. In short, a solid, inexpensive high-yield bond mutual fund is the way to go. Vanguard High-Yield Corporate (VWEHX) is one of the better funds in this corner of the market. With a rock-bottom 0.32% price tag and a measured, cautious approach to high-yield investing, this fund offers a safer way to invest in a very volatile asset class.

Despite the attractive returns junk bonds have been putting up lately, this is not a sector that investors absolutely need in their portfolios. If you do choose to invest now, do so fully aware of how much danger this sector currently presents.

For more personal financial planning and investing advice, check out the Fool's Rule Your Retirement service, which provides top-notch retirement and mutual fund recommendations. You can start your free 30-day trial today.

Amanda Kish is the Fool's resident fund advisor for the Rule Your Retirement investment newsletter. Amanda owns shares of iShares Barclays Aggregate Bond Index. The Fool has a disclosure policy.


Read/Post Comments (3) | Recommend This Article (2)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On December 02, 2009, at 7:58 PM, ladder03 wrote:

    It is very valid to say that this is not a stock price recovery based on fundamental economic numbers. The largest gains have come from quality financials that had gotten beaten down for no reason. More importantly, the recovery seems to just reflect risk apetite moving from DOA to barely breathing.

    I'm surprised the writer failed to mention iShares HYG ETF as a good way to enter high yield bonds. It's close to it's 52-week high though, so buy only if you hope for pre-2007 days.

    For more, visit: http://www.themoneyladder.com

  • Report this Comment On December 03, 2009, at 11:56 AM, geohjr wrote:

    When comparing high yield bonds to Treasuries keep in mind the Treasuries might actually be artificially or temporarily low.

  • Report this Comment On December 04, 2009, at 9:22 AM, whatsinaname2 wrote:

    Don't buy now for price appreciation as spread has narrowed. However, junk bond etfs do have a place in even moderate portfolios (especially when one considers company sponsored retirement plans typically do not offer this type of investment choice). Current yields are not overly compelling, but do offer a respectable yield. Keep in mind there is a built in premium (look at trade price vs. net asset value which changes real time).

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