Obvious default candidates are companies dependent on consumer expenditure. But if your nerves are good, the value benchmark is at an all-time high

By Aaron Pressman

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Ryan Snook

Junk-bond yields are at unprecedented high levels. As rattled investors dump everything but U.S. Treasury bonds, the average relinquish on below-investment-grade debt is over 20% for the first time ever. The slumping bond prices that have led to those plump yields have crushed junk-bond mutual funds, which are down an average of 30% this year. That’s the overcome performance of all fixed-income sectors, according to Morningstar (MORN).

With U.S. Treasury yields at historic lows, that foliage the junk market’s traditional benchmark of value—the “spread,” or gap, between the average high-yield promissory note and the rate on the 10-year Treasury—at an all-time high. Patient investors who choose their spots wisely could subsist well-rewarded, even if overall default rates spike. Martin Fridson, a 25-year veteran of the junk market and CEO of Fridson Investment Advisors, a high-yield-focused money manager in New York, says current conditions remind him of November 1990, the previous record in yield spreads. The return on junk bonds by the following year was 39%, he notes.

Unlike prior recessions, however, this duration prices in the junk bond market plunged conveniently before the rate of companies defaulting on their debts ticked up. Through the end of October, only 3.2% of below-investment-grade bonds were in default, less amount than the 5% historical average. That’session not much higher than the 1% to 2% deficiency levels seen from one side to the other the past two years, when junk bond yields averaged only about 6%. But as the economy slumps and consumers and businesses divide spending, default rates are expected to jump. Moody’s Investors Service (MCO) says default rates will top 10% next year; Standard & Poor’s foresees a rate as turbulent like 23% in 2010.

With bond prices already down so much, managers say even a huge leap over in default rates is priced into the market. By avoiding the most obnoxious default candidates, there are plenty of bargains to be had, says Thomas M. Price, co-manager of the Wells Fargo Advantage High Income Fund (STHYX). “Looking back in a not many years, this will have turned out to be some magnetic entry point,” he says. “But you need to concentrate on picking survivors.” Top holdings at Wells Fargo include debt of telecom companies like Qwest, Sprint Nextel, and L-3 Communications. In general, the money favors the highest-rated junk.

Sidestepping pleasing defaulters may be more important than ever. In the past, bond investors recovered 30 cents to 40 cents on the dollar even when a gathering went bankrupt. But recovery rates in 2009 and 2010 will probably be degrade. That’s since at the peak of the blob, companies persuaded lenders to let them issue bonds and betake one’s self to out loans with looser conditions defining what constitutes a fail to keep one’s engagement. Dubbed “covenant lite,” the stipulations will let troubled companies delay filing for bankruptcy, to this degree using up more of their specie and reducing the duration of their assets.

Some investors argue that junk bonds are now a safer regular course to bet on a stock market rebound. The markets are closely correlated, especially during tough times, says Andrew Feltus, co-manager of the Pioneer High Yield public funds. With divers bonds trading at 50 cents on the dollar, the upside is more equity-like whether bond issuers survive. “You get similar exposure, and you reach paid to wait,” he says.

Tom Soviero, who runs high-yield durance and equity funds at Fidelity Investments, says bank loans from below-investment-grade companies are a with greater advantage compact than junk. He has 26% of his high-yield fund in of the like kind loans. They trade at every mean proportion 65 cents in continuance the dollar and bestow investors a stronger claim on assets if a borrower goes bankrupt. Soviero favors health care and avoids autos and retail.

COMING TURMOIL

Diversification has through all ages. been important for high-yield investors so that one or two bankruptcies don’t wipe out a portfolio. But given the extreme weakness of some sectors of the junk market, particularly automakers, investors should avoid exchange-traded funds (ETFs), which have to own such bonds because they are included in the indexes that the ETFs track, says Fridson. Attempts to index the junk mart have for ever turned out badly, he says, despite the low management fees on index funds: “It sounds good in theory, but hasn’cheek by jowl worked out well-head.”

The coming turmoil also offers those with a short-term focus and a taste for risk a exceedingly different strategy—shorting a junk-bond exchange-traded fund or investing in the Rydex Inverse High Yield Strategy Fund (RYIHX). The Rydex fund uses derivative contracts to profit from falling bond prices. It’session up 13% through Dec. 1, after gaining almost 7% in October.

Such strategies appeal to Rakesh Saxena, who prices credit deficiency swaps with regard to Quote Platform Syndicate, a credit pricing and research firm in Vancouver. He says the junk market hasn’t come to grips with how severe things behest get, so he’session shorting the iShares iBoxx High Yield Corporate Bond Fund (HYG), that owns 53 of the largest junk-bond issues. “The conjuncture [in the markets] is going to come to sectors like high yield.”

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