It's time to get choosy about junk bonds

October 22, 2012: 5:00 AM ET

Investors seeking income are flocking to high-yield bonds, prompting fears of a bubble. Here's how to minimize your risk.

By Janice Revell, contributor

FORTUNE -- There's a raging bull market in junk bonds these days. Thanks to the Federal Reserve's ongoing efforts to juice the economy with ultralow interest rates, income-starved investors have been flocking to riskier, but higher-yielding, corporate bonds. Many observers are now warning of a bubble. However, it's not too late to add junk to your portfolio -- as long as you choose very carefully.

Junk (a.k.a. "high-yield") bonds are issued by companies with less-than-stellar credit ratings; in return for a greater risk of default, they offer fatter yields. So far this year, investors have poured a record $53 billion into high-yield bonds, according to fund-flow tracker EPFR Global. In the process they've driven up prices and caused yields (which move in the opposite direction of bond prices) to sink to record lows. The average junk bond now trades well above par value -- at about 104¢ on the dollar -- and yields just 6.2%.

Those lofty prices mean that you can expect lower returns going forward. Through mid-September, high-yield bonds had generated a total return of more than 10%. While just over half of that came from interest payments, a whopping 47% came from price appreciation. And that simply can't last, say experts. "Investors need to lower their expectations," says Kathy Jones, a fixed-income strategist at Charles Schwab.

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If you do want to try your hand at junk, here's what you need to know. The difference between the average yield on all junk bonds vs. ultrasafe Treasuries with comparable maturities is currently about 5.3 percentage points, a spread that's in line with the historical average. But most pros advise investors to avoid the lowest-rated junk bonds. A more prudent choice: bonds that are rated just one notch below those of high-quality investment-grade issuers. Right now those BB bonds are yielding about four percentage points over comparable Treasuries.

It's also a good idea to choose junk bonds with shorter maturities. Bonds with longer-term maturities may offer a higher yield today, but their prices are far more susceptible to getting walloped if future interest rates rise. "This is not the time to be stretching for that kind of additional yield," says Samuel Lee, a fixed-income analyst for Morningstar. The easiest way to gain exposure to junk bonds is through purchasing a mutual fund or ETF. Lee's top choice is the Pimco 0-5 Year High Yield Corporate Bond Index ETF (HYS).

Just don't overdo it. Over the long haul, the returns for junk bonds track more closely to those of stocks than nonjunk bonds. So if you transfer a large chunk of your existing bond holdings into high-yield, you'll actually reduce your diversification and increase the volatility of your portfolio. For that reason, advisers recommend that most investors limit their high-yield allocation to no more than 20% of their overall bond holdings. When it comes to junk, a little goes a long way.

--A former compensation consultant, Janice Revell has been writing about personal finance since 2000.

This story is from the October 29, 2012 issue of Fortune.

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