After Big Year, Junk Bonds May Have Smaller Gains in 2010

Talk about a dash to trash.

Investors have poured over $30 billion dollars into junk bond funds this year, according to AMG Data Services, after a flight to quality in 2008 crushed prices of low-grade corporate debt.

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Junk bonds have returned a monstrous 56% thus far this year, according to Morningstar—10 percentage points better than the previous record gain set in 1991. Over the same period, the total return on US Treasurys is down 2.4 percent..

“For performance-chasing investors, junk was the only game in town,” says John Lonski, chief economist at Moody’s Capital Markets Group.

But is the game in what’s now a near trillion-dollar market over?

With the current spread between high-yield bonds and Treasurys about 1.3 percentage points above the long-term average, experts say there is still room to run. Just adjust your expectations, they say. The current spread is down from an eye-popping 20 percentage points last fall.

“This suggests that most of the profits have already been squeezed out of this sector, and the easy money’s been made,” says Lonski.

That’s not to say returns won’t be healthy going forward, says Martin Fridson of Fridson Investment Advisors. In fact, he expects junk to outperform other credit instruments in 2010.

“Because high-yield bonds rise and fall with the trends in corporate earnings, they stand to benefit more than other sectors of the fixed-income market from further improvement in the economy.”

And, if interest rates rise next year, as many economists expect, Fridson says high-yield bonds will be in a “favorable position” because they’re less rate-sensitive than higher quality issues.

Fridson is expecting a 10 percent return over the next 12 months—assuming the economic recovery continues and that there’s no double dip recession. His projection also assumes a stabilizing default rate of 5 percent—down from 12.7% over the past 12 months, according to Moody’s, and just one percentage point above the historical average of 4 percent.

Other analysts are less optimistic. Tony Rodriguez, head of fixed income at FAF Advisors, says while junk may indeed be an attractive asset class for 2010, there are headwinds to consider. Consumer sentiment is weak, as is the employment outlook. That makes sector selection more critical than ever.

“Unlike in 2009, where you had all these across-the-board plays, you have to be discriminating to get a decent return.”

Thus, Rodriguez is underweight in sectors that depend on consumer spending, like retail, restaurants and gaming. He prefers sectors that are exposed to – and will benefit from - a stabilizing global economy, such as chemicals, packaging, energy and airlines.

Retail investors who want in on the action—and can stomach the risk—should proceed with caution, says Marilyn Cohen, author of “The Bond Bible” and president of Envision Capital Management.

“Things are looking a bit bubbly," says Cohen.

To hedge your bets, she says no more than 10 percent of your portfolio should be in junk bonds and don’t invest new money if the spread is shrinking below 5 percent.

“You’ve got to demand at least 5 percentage points or you won’t be adequately compensated for the above-average risks,” says Cohen, who also advises investors to buy junk solely through funds.

Vanguard High Yield Corporate, for instance, has $5.5 billion under management, and boasts a rock bottom 0.32 price tag.( annual fee). Year to date, the fund is up 38 percent (versus. an average annual return of 20 percent in the 1991-1993 junk boom.)

“This is the low-cost provider,” says Cohen “If you want a measured, cautious approach to high-yield investing this is it.”

Another category leader—based on returns, and other quality measures such as expenses and management style—is T. Rowe Price High-Yield Fund .

It has $5.0 billion under management, and levies an annual fee of 0.80 percent. Year to date, the fund is up 47 percent, versus a 1991-1993 average of 23 percent.

“Their holdings are solid; their stuff’s not dicey,” says Cohen.

High-yield exchange traded funds—which have tripled in size since the beginning of the year to $7.3 billion – are another way to get in.

The top performing ETF, SPDR Barclays Capital High Yield Bond is up 49 percent over the past year.