You don't have to go to the bottom of the barrel to find junk bonds offering good value and high interest payments. Lars Berkman, portfolio manager of the Prudential High Yield Corporate Bond fund, suggests that today's bonds are of significantly higher credit quality than those issued during their heyday in the late '80s and early '90s. "During the recession of 1990, the default rate was 10 percent," says Berkman. "Underwriting quality was weaker in the '80s than it is today. [Price] spreads on new deals are lower, but quality is higher: The default rate is now between 1 percent and 2 percent." He believes the default rate will remain low and losses will be less common, provided the economy continues to grow.
An initial foray into high-yield investing can be daunting, and as always, don't put all your eggs in one basket. The simplest plan is to mix and match your fixed-income portfolio according to your risk tolerance. Consider investing at least half your allotted sum in high-grade Treasury bonds of intermediate maturity, yielding about 6 percent. This will keep part of the portfolio low risk, as these bonds are backed by the full faith and credit of the U.S. Treasury. The only problem is that in a stable rate environment, Treasuries tend to underperform other types of bonds. So with the other half of your fixed-income portfolio, try to increase your yield with a few high-yield corporate bonds.
Most experts recommend that small investors--in other words, those with fewer than six figures to place in any particular class of investments--stick with bond funds. While individual bonds may sound scintillating, if you select five issuers and one goes bankrupt, you could sustain a severe loss. Instead, choose a high-yield bond fund with a substantial track record that matches your objectives and goals. Remember, past performance is no guarantee of future results, and, as always, read the prospectus before you invest.
Berkman suggests different kinds of funds for different kinds of investors. For more aggressive investors, lower-grade junk bonds can provide a potentially high return but at substantially higher risk. For the more conservative, higher-grade junk bonds can provide income and diversification without betting the ranch.