Bad Times, Good Junk

Now that we're in a recession, a lot of junk looks more valuable: those "classic" sport jackets in your closet, the aging but paid-for SUV in your driveway--and, get this, the bonds of companies with poor credit. That may sound crazy at first. Recessions are always tough on companies operating at the edge of solvency--those most likely to have high-risk, high-yield junk bonds outstanding. Yet diversified pools of these bonds typically do well at this point in an economic cycle.

As ever, diversification is the key. Only the wealthiest and most sophisticated investors should dabble in individual junk-bond issues. The risk of any single company's failing is too great. But a diverse portfolio--easily obtained through junk-bond mutual funds--brings the investment risk way down and makes junk bonds suitable for most investors.

Since 1985 junk-bond funds have returned an average annual 6.3%, according to fund tracker Morningstar. That's nowhere near the 14% from stocks in the same period. But it's unlikely that stocks will keep up such a torrid pace. Their long-run return is about 10% a year, and even that mark may be hard to achieve for a while. Yes, stocks have fallen sharply and are cheaper. But their recovery will be hampered because they remain expensive relative to earnings, dividends and book value.

Junk bonds, on the other hand, have rarely been so cheap. They carry an average yield of about 12.25%, vs. about 5% for the benchmark 10-year Treasury bond. The difference between those yields, known as the spread, represents a hefty premium of 7.25 percentage points. The long-run average spread of junk over T-bonds is just 4.25.

One reason for the higher spread is that we're in a recession and junk-bond default rates have been rising well beyond the average 3.5% a year. Nearly 1 in 10 junk-bond issues has stopped paying interest, and Martin Fridson, chief high-yield strategist at Merrill Lynch, predicts the rate will rise further next year--probably narrowly topping the record default rate of 10.3%, in 1991. But that will be the worst of it, he says, and he notes that "the last time we had record default rates, we had record returns."

In 1990, with the onset of a recession, the average junk-bond fund fell 10%. Then it surged 37%, 18% and 19% over the next three years. During a slowdown in 1994, junk-bond funds fell 4% but then rallied more than 12% in each of the next three years.

This pattern makes sense. Investors look ahead to recovery, when the default rate will drop and make the lush yields on junk bonds more secure. That leads investors to bid up junk-bond prices, resulting in a capital gain. "We've already seen some junk bonds rally," says John Fenn, head of high-yield investments at J.P. Morgan Fleming Asset Management. Next year, he believes, junk bonds will deliver on their eye-popping 12% yields and produce a capital-gain kicker worth an additional 5% to 10%--for a total return of about 20%.

Junk bonds didn't get their name for no reason. If the recession worsens, default rates will continue to rise and returns will suffer. A period of widespread price deflation in goods and services, which some have argued is a risk, would be especially tough on companies struggling with hefty interest payments. Barring such developments, though, the bad news is already priced into the market.

Of course, not all junk-bond funds are created equal. Those heavily concentrated in telecommunications bonds have been beaten up the worst. Examples include the 26% slide so far this year in the Morgan Stanley High Yield Fund and the 19% drop in the Invesco High Yield Fund--at a time when the junk-fund benchmark is up modestly. Scott Berry, an analyst at Morningstar, advises staying away from such funds because most telecom bonds will remain depressed. Two of his favorite funds are Northeast Investors Trust and Pimco High Yield, which have shied away from telecom bonds and, in Pimco's case, kept some investment-grade bonds in the mix for stability. For a slightly higher-octane play, he likes Strong High Yield and Fidelity High Income, which have navigated a tough climate well and have enough lower-quality bonds to supercharge returns as the economy improves and such bonds snap back.

TIME.com See time.com/global for more on junk bonds, and see Dan each Tuesday on CNNfn's MoneyGang at 2:35 p.m. E.T.