Bonds: There’s gold in that junk

Does an 18% yield sound attractive to you? If so, you may want to consider investing in the wonderful world of junk bonds.

Junk bonds are issued by firms with shaky credit —the ones that have to pay extra to convince investors to lend them money. These bonds aren’t officially labelled as “junk,” of course. They’re more politely known as high-yield bonds.

As you can see from the accompanying graph, high-yield bonds now pay north of 18% a year. The yields have shot up in recent months as a sickening economy has increased worries that marginal firms may start defaulting on their bonds. To compensate for the extra risk, investors are demanding higher and higher yields.

The current yields look very tempting indeed. During the last two recessions the default rate for these bonds peaked near 12%, which suggests that at their current prices, highyield bonds offer a healthy margin of safety even in a nasty recession.

If you’re intrigued about the potential of this market, forget about buying individual bonds. The risk is high that you’ll guess wrong and pick a dud. Instead, buy a diversified selection of bonds. The iShares iBoxx $ High Yield Corporate Bond (HYG) is an exchange-traded fund that trades on the New York Stock Exchange. It gives you exposure to a wide range of high-yield bonds and charges only 0.5% per year in fees. If you prefer to rely on a manager’s expertise, Chou Bond fund is a good pick even if its management expense ratio is 1.34% per year. Just remember, high-yield bonds aren’t for the faint of heart and most people should only put a small fraction of their portfolio into them.