Waggoner: Are junk bonds trash or treasure these days?

ByABC News
June 21, 2012, 9:43 PM

— -- Every day, we balance risk and reward. Wait for the walk sign, or sprint across the street? Spend the night watching TV, or rolling bowling balls off the roof? Read about bears, or teach one to yodel?

As it is in life, so it is with investing. For those poor souls trying to get a bit of income from their portfolios, they can take no risk and live on a diet of boiled gravel, or they could put part of their money at risk and get a higher yield.

Junk-bond funds are an excellent example of trading risk for reward. The average junk bond yields 7% to 8%, vs. 1.62% for the riskless 10-year Treasury note. With that extra yield comes risk: They're not called junk bonds for nothing. Is the trade-off worth it? Probably. But when you make a bet on junk bonds, you're betting on a healthy economic recovery, something that many economists are starting to worry about.

Junk bonds, euphemistically called high-yield on Wall Street, are long-term IOUs issued by companies with questionable credit ratings. Just as people with bad credit have to pay higher rates than those with sterling credit, corporations do, too.

In theory, a diversified portfolio of junk bonds will perform better than high-rated corporate debt, because the bonds' high yields will offset losses from defaults. Most of the time, that has been the case.

The past 15 years, the average junk-bond fund has gained 5.18% a year, vs. 4.72% for the average large-company blend fund, according to Morningstar. (A large-company blend fund is one that invests in the biggest U.S. companies. It looks for stocks of companies with growing earnings selling at reasonable prices.)

Junk bonds have not beaten their more creditworthy brethren, however. Funds that invest in high-rated corporate bonds are up an average 5.77% in the past 15 years. The reason junk has lagged: These are perilous times, and investors are willing to pay a premium for safety. Long-term government bond funds have trounced junk and corporate bond funds, rising an average 9% a year.

Why have junk funds lagged? In a word, terror. The 2007-2009 meltdown sent investors fleeing to safety, dropping their riskier investments, such as junk bonds. The worst 12 months for junk-bond funds ended in November 2008, when the average junk fund plunged 30.1%.

Junk funds have had other periods of negative total returns — interest plus price change. The funds posted 12-month losses during the 2000-2002 bear market, as well as in the 1990-1991 recession. If you notice a theme here, it's that junk funds are economically sensitive, which makes sense: In a recession, shaky borrowers are more likely to default. This brings us to the question of whether it's a good time to invest in junk now.

One way to look at the question is how junk-bond buyers are behaving. If they are pushing yields up, they're worried. The current temperature is mildly elevated. According to Moody's, junk bonds yield an average 6.83 percentage points above Treasuries. The average since 1990 is 5.61 percentage points, according to John Lonski, Moody's chief economist. For now, some of the worries are unfounded. More companies had their ratings upgraded than downgraded in the first quarter, Lonski says. And bondholders stand a much better chance of getting something back in the event of a default.