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Junk or Jewels? The Lowdown on High-Yield Bonds

After a year in which junk bonds were anything but junky, the outlook for high-yield fixed income is about to get murkier.

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Just as the stock market rally suddenly is looking tired and vulnerable, the surge in prices for riskier corporate debt appears to have run its course.

The space is probably a victim of its success as much as it is endangered by an uncertain time ahead, analysts say.

With the presidential election over, market focus will turn to mediocre corporate earnings, an uncertain climate in Washington and the possibility of recession lurking ahead. (Read More: Why US Economy May Be Headed for Another Recession)

"Despite the favorable liquidity conditions and the demand for yield, we expect to see U.S. high yield names begin to underperform investment grade credit and US [Treasurys] as we head into 2013," Thomas Tzitzouris, fixed income strategist at Strategas, said in a recent analysis of the group.

Strategas cut high yield to an underweight position in its recommended portfolio, basing the move on several factors. (Read More: Fixed-income market outlook.)

The firm sees a near-certainty of a recession as 2013 begins and believes investors need to prepare for a "fiscal cliff shock" related to government negotiations over how to avoid the series of tax increases and spending cuts set to take place Jan. 1.

While Tzitzouris said there could be a good re-entry point later in the year as the economy stabilizes, he recommends investors back off for now.

"With the U.S. likely moving towards a recession in the first half of 2013 [the fiscal cliff shock], and top line growth and earnings margins now both seemingly heading lower, it seems that U.S. corporate sector spreads may be about to begin a move higher in the next few quarters," he said.

Higher spreads between junk bonds and safer instruments indicate a greater level of corporate default risk. That would come with more difficult business conditions that a recession and a less-friendly business tax climate would impose. (Read More: Obama to Insist on Tax Increase for Rich)

The high-yield performance in 2012 has been nothing less than stellar, with yields falling below 7 percent as prices rose. The Barclays Corporate High Yield Index stood at 6.60 percent on Friday.

Investors are increasingly turning toward exchange traded funds to play in the high-yield arena.

The iShares iBoxx High Yield Corporate fund has returned about 9 percent in 2012 and is up on average by more than 10 percent over the past three years. The $16.63 billion fund yields 6.78 percent, according to Morningstar.

For deep-pocketed investors, the Federated Institutional High Yield Bond has been a stellar performer, returning 12.8 percent this year and yielding 7.33 percent. The fund, however, requires a $1 million minimum investment.

Whatever the choice, high yield has been a favorite space, though one about to be tested.

"There's been a lot of verbiage from various big gurus saying high yield is overvalued, don't touch it with a 10-foot pole," said Marilyn Cohen, founder of Envision Capital Management in Los Angeles. "My counter to that is, 'All right, so you're going to sit in cash or T-bills or corporate bonds, which are trading at lower yields than Treasurys.'"

Indeed, the search for yield away from the government and investment-grade corporate debt has been the driving force behind the junk surge.

"If you're careful and nimble — those are the two operative words — high-yield is the only place that offers yield. It isn't high yield, but it's yield," Cohen said. "There are no bargains in junk bonds, there are no bargains anywhere. There are no bargains in the stock market. All these markets have been wrung out."

Cohen advises investors to look for "good quality companies in which you understand the business."

Among her recommendations are offerings from Hertz, Smithfield Foods and Hanes. In the ETF space, she favors the Peritus High Yield fund, which has returned 12.5 percent and yields 8.37 percent, though its expense ratio is high at 1.35 percent

"Keep it simple," she said.

Cohen also believes high yield should take on a smaller portion of investor bond portfolios, with an allocation of no more than 20 percent.

How well the negotiations over the fiscal cliff go in Washington likely will go a long way in determining the extent of the economic slowdown, and the future for high yield. (Read More: Fixing 'Fiscal Cliff' Will Mean 'High, Higher' Taxes: Gross)

Investors should keep duration shorter, within seven years or so, and focus on industries "that aren't going to go defunct" with the inevitable popping of the bond bubble, said Keith Springer, president of Springer Investment Advisors in Sacramento, Calif.

Springer likes DD-rated bonds, and citedAllyFinancial as one company whose debt is worth a look.

"The fiscal cliff will see them at least kick the can down the road," he said. "I don't think that's going to affect the high-yield market that much. If you're yield-starved you have to go somewhere."

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