High-grade corporate bonds look decent

— -- When you were a wee tyke and you tried to grab some of Grandma's freshly baked high-yield securities, she probably whacked you with a rolled-up prospectus and said, "Don't reach for yield!"

Well, Granny was right: People who dug into high-yield, high-risk junk bonds got burned pretty badly the past 12 months. And high-yield bonds are still too hot to handle. But you can find some tasty high-grade corporate and municipal bonds these days.

When you buy a bond, you're buying a long-term IOU. If you buy the current 10-year Treasury note, for example, the government promises to pay you 2.75% a year for a decade. A $10,000, 10-year T-note, then, would pay you $275 a year. When it matures, the Treasury will repay your $10,000 principal.

In the case of the Treasury, credit risk isn't a concern: If the government doesn't have the money, it can always print some more. Printing money is inflationary, and we'll get to that in a bit, but you can bet that if the government borrows $10,000 from you, you'll get $10,000 back.

Things get a big murkier if you lend money to a corporation by buying a corporate bond. Companies can't print money, and sometimes they go out of business altogether, transforming their bonds into very nicely engraved fish wrap. Corporate bonds usually yield more than Treasury securities, because investors want to be paid extra interest for taking on the risk of default.

Because of the recession, defaults have been unusually high, and they are headed higher, says Moody's Investors Services. The current global default rate is 7% of all issuers, up from 4.1% at the end of 2008 and 1.5% just 12 months ago.

Things are likely to get worse before they get better. Defaults rise well after the economy bottoms. Moody's sees global default rates peaking at 14.6% in November.

Because default risk has soared, so have yields on corporate bonds. As with people, companies with the worst credit ratings pay the highest interest rates on their loans. Wall Streeters call bonds with very high yields "junk bonds"; they have really rotten credit ratings.

How high are the yields? Sky high. Junk-bond yields averaged 11.62 percentage points more than comparable Treasury yields in March, which is slightly below the rates they would get from slapping their debts onto their Visa card. Junk yields have averaged 5.37 percentage points over Treasuries the past five years, says Diane Vazza, head of global fixed-income research at Standard & Poor's.

For junk-bond investors, rising rates and soaring defaults is like breaking your leg in the pneumonia ward. Suppose you owned a $10,000 bond issued by TrashTalk, a fictitious maker of talking garbage cans. The bond paid $600 a year in interest at issue, or 6%.

But TrashTalk's credit rating got downgraded, and companies with similar ratings pay 14% in interest. Fortunately for TrashTalk, the bond's interest payment is set until it matures. And you'll still get your $10,000 back if you hold the bond to maturity and TrashTalk is still around.

If you try to sell the bond before it matures, however, traders will slash the price of the bond until the yield — interest payment divided by price — equals 14%. In this case, the bond's price would fall to $4,285 — $600 divided by $4,285 is 14%.

Junk-bond investors have lost an average 21% the past 12 months, according to Lipper — and that's including reinvested interest. Although junk yields have fallen a bit, analysts are still wary. "This is a real son-of-a-gun of a cycle," says Dan Fuss, manager of Loomis Sayles Bond. "Trends are pretty uniformly negative."

Nevertheless, high-grade corporate bonds offer decent yields: 4.86 percentage points higher than Treasuries, says Standard & Poor's Vazza. But even in high-grade corporates, you need to be careful, Fuss says. He thinks the inflation rate will rise over the next five years, ushering in a long cycle of slowly rising interest rates. If you buy a bond now that yields 4% and rates rise to 6%, you'll be kicking yourself.

So if you're looking for income, consider a relatively short-term, high-quality corporate bond fund. You won't get a whopping big yield, but you won't run the risk of getting burned, either. All things considered, that's not such a bad trade-off.

John Waggoner is a personal finance columnist for USA TODAY. His Investing column appears Fridays. new book,Bailout: What the Rescue of Bear Stearns and the Credit Crisis Mean for Your Investments, is available through John Wiley & Sons. Click here for an index of Investing columns. His e-mail is jwaggoner@usatoday.com.