Don't Trash Those Junk Bonds

Jan. 22 -- These might be the worst of times for high-yield bond funds, but that's also why they're worth a look.

High-yield, or junk, bond funds invest in bonds issued by companies — often tech and telecom shops — with less-than-perfect credit. Thanks to recession worries, a downtick in corporate spending on tech and telecom equipment and the looming threat that more of the upstart telecom firms will fold without paying their bondholders, these funds have had rough time. The average high-yield fund has suffered an annualized loss of 1.4 percent over the past three years, according to Morningstar. In 2000 the average fund dropped more than 9 percent, more than any other bond-fund flavor.

"I think a lot of the bad news is already priced in to high-yield bonds," says Scott Berry, a bond fund analyst at Morningstar. "Even if the economy has a hard landing, I think these bonds should do OK this year. Some analysts are calling for 20 percent or 30 percent returns, and I'm not in that camp. But I think folks might make back what they lost over the last year and maybe some more."

What are bonds? For details, check out our basics section's primer on bonds , junk bonds and bond funds .

Amid all this bad news for high-yield funds, there may be a silver lining. Investors may have gotten too negative, leading savvy investors like Bill Miller and Ken Gregory to name high-yield bonds as a great opportunity over the next three years. Both believe today's high-yield bond prices are too low, and if falling interest rates coax more investors to dip a toe into the high-yield market, they could be proved right. Consider that so far this year the average high-yield fund is up more than 4 percent, beating all fixed-income categories and all stock fund categories, aside from communications funds.

So even though these funds shouldn't be your core bond holding, they should be part of a diversified portfolio and now might be a good time to add one. To help you see what's out there, we've done some homework by screening the category to single out funds that beat their average peer over the past one-, three-