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. Last Updated: 07/27/2016

Investors Rediscover Junk Bonds

BALTIMORE, Maryland -- The last place anyone might think of as a safe haven for his money is the junk bond market.


Remember junk bonds? They were the securities embraced by Michael Milken, who used them to finance scores of corporate takeovers in the 1980s. They crippled companies under crushing debt, forcing layoffs and failures.


But stack up the performance of junk bonds against corporate bonds, and the results are eye-opening. Junk bonds, or high-yield bonds, have consistently beaten corporate bond funds on an annualized basis over the past 10 years.


In 1995, for instance, 151 junk bond funds had a cumulative 16.37 percent return, compared with 15.63 percent for 642 corporate bond funds, according to Morningstar Inc., a Chicago-based research and publishing company that tracks the mutual fund industry.


And for the first half of this year, junk bonds had a total return of 4.81 percent, compared with a negative 0.90 percent for corporate bond funds.


"This has been the year to own the K-marts of the world," said Mark Wright, a Morningstar analyst, who follows the junk bond market.


Unlike the highest rated bonds, which are rated AAA, junk bonds are speculative because it's unclear if the issuer has the ability to pay interest and repay principal. They are issued by companies heavy with debt and pay higher yields because of the risk.


A junk bond rated "BB" indicates the lowest degree of speculation, while one rated "CC" is the highest degree.


Investors should have at least 5 percent to 10 percent of their portfolio in junk bonds, experts say.


"They offer good diversification from stocks," Wright said. "They have a high expected rate of return over the long haul. I think they are ideal for long-term investors. When I look at my portfolio, I want to try to own as many different types of assets that will ... behave differently."


But junk bonds carry plenty of baggage. Their name alone doesn't inspire confidence.


"People tend to think those are very high-risk investments, but only about 3 percent of junk bonds per year go unpaid or the companies go belly up and file for bankruptcy," said Tom Byrne, director of research with Individual Investor Group, a New York financial publishing and money management company. "On that level, there is a huge misinterpretation. They are probably not as risky as most people think."


Junk bonds are frequently associated with 1980s recklessness when billions of dollars were raised to finance the acquisition of companies that weren't credit worthy. The practice often ended in disaster for thousands of employees who were fired after debt-laden companies were either forced into bankruptcy or forced to sell off huge pieces of the business.


Many of these deals were masterminded by "junk bond king" Milken, who ended up spending time in prison for violating securities laws.


"It is still a controversial investment," said Mark Vaselkiv, president of T. Rowe Price High Yield Fund and executive vice president of T. Rowe Price Corporate Income Fund.


"But we enjoy explaining to people that it is not poison like you think it is. I think [junk bonds] really surprise people, not only in the returns, but in the lower volatility as well."


Unlike bonds, which perform well when the economy is gloomy, junk bonds perform well when the economy is healthy. And they are less volatile than bonds, which move up and down on interest rates. Junk bonds fluctuate on credit risk and the strength of the economy.


The best way to invest in junk bonds is through mutual funds, which offer variety and a cheaper way to get into the high-yield market. But investors should pay attention to the fund's five-year track record and whether the mutual fund's management has been stable, experts say.


Some top-performing junk bond funds include Janus High Yield, up 13.96 percent in the first half of this year; Strong High Yield Bond, up 13.89 percent; and Touchstone Income Opportunity A Shares, up 11.58 percent.