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:

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.