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How Toxic Are Your Junk Bonds?

March 19, 2016, 3:00 PM UTC
Mark Allen Miller

The average high-yield bond currently pays about 8.5% in interest, roughly seven percentage points more than comparable Treasuries. Historically, that spread between junk bonds and Treasuries has been 5.4 points, according to Andrew Susser, portfolio manager for the MainStay High Yield Corporate Bond Fund. The big question for investors is whether today’s unusually big spread represents a great opportunity—or a trap.

Junk bonds have high yields for a reason, of course: They’re issued by less creditworthy companies that have to pay lenders more. Junk bond investors weigh that higher income against the risk of a default that could wipe out their investment. With rates so low on safer bonds like Treasuries, many mom-and-pop investors and retirees looking for an income source have decided that high yields are worth a few sleepless nights. But bond defaults tend to rise, and prices to fall, when the economy weakens. That dynamic played out over the past year, as investor jitters caused Bloomberg’s junk bond index to fall 11.8% from May 2015 to February 2016. While junk bonds have partially rebounded, today’s high yields reflect enduring fears about what’s to come.

Still, some pros argue that high-yield bonds are a good buy at today’s prices, even if a downturn looms. The key, says Michael Fredericks, portfolio manager of the BlackRock Multi-Asset Income Fund, is to focus on that investment oxymoron, high-quality junk. During the recent high-yield slide, bonds rated CCC or lower, the bottom of the credit-­rating barrel, lost 22% of their value, according to Morningstar; BB-rated junk bonds, at the high end of the spectrum, lost only 6%.

The good news is that many mutual funds focus on higher-rated junk. If prices do have further to fall, funds like these limit losses. That can position investors to capture decent longer-term gains: The 10-year annualized return of the Bank of America Merrill Lynch (BAC) U.S. High Yield index, for example, is 6.5%, on par with the S&P 500—and that includes a very rough patch during the 2008–09 financial crisis. Among funds focusing on higher-quality credit, Todd Rosenbluth, director of ETF and mutual fund research at S&P Capital IQ, recommends the iShares iBoxx High Yield ETF and the Janus High Yield Fund, which both hold most of their portfolios in bonds rated B or higher.

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The pros’ overall advice: Treat junk bonds like stocks—higher-risk, higher-reward investments for the long term. Andrew Dierdorf of Fidelity Freedom Funds recommends holding no more than 10% of your portfolio in junk, and as little as 3% in iffy times like these, especially if you’re in, or close to, retirement. 

A version of this article appears in the April 1, 2016 issue of Fortune.