No pain, no gain. That's the mantra of the high-yield bond investor who is willing to assume the default risk of a bond if its yield and price seem worth the wager.

Relentlessly bad news and constant warnings about debt risk here and abroad, coupled with the recent extreme volatility of the junk bond market, mean even more courage is required in 2011.

Junk bonds remain a viable market for yield-seekers, but only for a small portion of an individual's portfolio. Anyone who believes the economy will worsen shouldn't consider them at all because debt of companies with subpar credit is not for the faint of heart.

The average high-yield bond mutual fund has a one-year total return of 13 percent and a three-year annualized total return of 10 percent, according to Lipper Inc. Funds provide a diversified portfolio of the bonds of hundreds of companies, so you aren't saddled with one company's uncertainties.

Some experts see potential for a junk-bond rally based on recent investor overreaction, but that is not a sure thing. Although merger-and-acquisition financing has driven this year's market, some planned high-yield issues were pulled back, and investors continue to exit the market.

There are, however, good things to say about companies issuing high-yield bonds.

"In spite of all the bad macroeconomic news, when high-yield companies are viewed at the fundamental corporate level, things still look good," noted Michael Kessler, credit strategist with Barclays Capital in New York. "The ratings momentum this year has been overwhelmingly positive, and more companies are getting upgraded than downgraded."

Far more companies have gone from being junk issuers to investment grade than the other way around, Kessler said. The recession was very severe and default rates went up a lot, so companies that survived were those that "got religion" quickly, he believes. They made progress on the strength and liquidity of balance sheets.

[See 50 Best Funds for the Everyday Investor.]

The rating of bonds by credit-rating agencies, in descending order, is AAA, AA, A, BBB, BB, B, CCC, CC, C and D, with anything BB or worse generally considered a junk bond. Kessler believes investors interested in individual junk bonds should only seek out those in which the company could potentially be upgraded to investment grade or is significantly reducing its debt.

"While I personally don't love the high-yield bond sector right now, if the economy rebounds from its recent soft patch and shows improvement, it should do just fine," said Mark Salzinger, editor and publisher of The Investor's ETF Report (www.noloadfundinvestor.com), Brentwood, Tenn. "A mild slowdown wouldn't be a big deal for exchange-traded funds, and the yield advantage will win out over fears that credit will go down."

If a "really bad" recession unfolds, high-yield bonds "will get killed," Salzinger warned, because their yield won't be high enough to offer any kind of protection in a truly difficult period.

With that caveat in mind, Salzinger believes high-yield still has some worthwhile exchange-traded funds (ETFs, which trade on an exchange):

-- The $8.9 billion iShares iBoxx $ High Yield Corp. Bond (HYG) has one-year annualized total return of 11 percent and three-year annualized total return of 9 percent. It holds nearly 500 bonds with an average credit quality of B and an average duration of 4.3 years.

-- The $7.4 billion SPDR Barclays Capital High Yield Bond (JNK) has one-year annualized total return of 12 percent and three-year annualized total return of 10 percent. It holds more than 200 bonds with average credit quality of B and average duration of 4.6 years.

"For a portion of growth investors -- not just income investors -- high-yield bonds should represent a place to have money invested," said Adam Bold, founder of The Mutual Fund Store in Overland Park, Kan. "Since I expect interest rates to rise in the next 12 to 18 months, fixed-income investors can find some refuge in high-yield bonds."

Even though high-yield mutual funds remove some risk through diversification, Bold cautioned, investors should be fully aware that there will be more volatility than with other kinds of bond funds. That's why he believes junk should only be used for a small percentage of an individual's portfolio.

[See 6 Investing Ideas for Today's Slow-Growth Economy.]

Again keeping risk in mind, Bold offers some high-yield bond mutual funds worthy of investor consideration:

-- The $3.6 billion Artio Global High Income Fund (BJBHX) has one-year annualized total return of 13 percent and five-year annualized total return of 9 percent. It holds about 200 bonds with average credit quality of B and average bond duration of 3.2 years. This "no-load" (no sales charge fund) requires a $1,000 minimum initial investment and has an annual expense ratio of 1 percent.

Portfolio manager Greg Hopper has run the fund since its late-2002 inception and is backed by a team of portfolio managers and analysts.

-- The $8.4 billion T. Rowe Price High Yield Fund (PRHYX) has one-year annualized total return of 13 percent and five-year annualized total return of 8 percent. It holds more than 500 bonds with average credit quality of B and average bond duration of 3.6 years. It has no load, requires a $2,500 minimum initial investment and has an annual expense ratio of 0.74 percent.

Portfolio manager Mark Vaselkiv has run it since 1996 and is assisted by a team of analysts and traders.

 

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(c) 2011 Andrew Leckey, Tribune Media Services