By JACK HOUGH
For investors with an appetite for risk, high-yield or "junk" bonds can provide a big boost to income.
But so much money has recently poured into junk bonds issued by companies that investors should turn their attention to ones issued by state and local governments, which look like a better deal.
Junk bonds have a higher risk of default than bonds labeled "investment grade" by Wall Street. Investors buy them for their relatively high yields.
For example, the Barclays U.S. Corporate High Yield index, which tracks nearly 2,000 junk bonds, yielded 6.8% on Thursday. The 10-year Treasury note, which has negligible risk of default, yields just 1.7%.
Over long periods, an average of 4.2% of junk bonds default each year, and investors recover an average of 44% of their money from junk bonds in default, according to James Swanson, chief investment strategist at MFS Investment Management in Boston, which manages $285 billion.
Even after trimming that 6.8% yield by two or three percentage points to account for expected losses, the yield that is left is more generous than the 10-year Treasury yield. And over the past year, the default rate for corporate junk bonds has been lower than usual, under 3%.
That might seem like a reason to load up on corporate junk bonds, but be careful. They have gotten pricey.
During the first half of this year, $27.1 billion flowed into corporate-junk-bond funds, compared with $15.6 billion for all of 2011. All that buying has pushed junk-bond prices higher, and yields, which move opposite from prices, lower. The yield on that Barclays U.S. Corporate High Yield index has dropped by 1.6 percentage points so far this year.
At the same time, U.S. economic growth has slowed--to an annualized rate of 1.5% during the second quarter from 2% in the first quarter and 4.1% in the fourth quarter of 2011, according to the Commerce Department. If the economy weakens further and corporate profits slump, defaults for junk bonds could rise.
And if that happens, it won't matter that junk yields beat Treasury yields, says Sarah Bush, a bond-fund analyst at investment-research firm Morningstar. What will matter is whether corporate junk yields are high enough to offset defaults, and that isn't clear.
Municipal bonds, by contrast, offer better deals for junk buyers, says George Rusnak, director of fixed income at Wells Fargo's wealth-management division.
One reason: They have made less of a comeback than corporate junk bonds since the financial crisis of 2008, when both plunged (see chart). Investors remain deeply cautious on municipal junk issues, even though, according to a recent analysis by Moody's, their default rates over the past four decades have been three-quarters lower than those for corporate junk issues.
Also, after junk-muni defaults, the amounts recovered by investors have been higher than after junk-corporate defaults.
What's more, municipal-bond income escapes federal taxes in most cases. Usually, that tax advantage is offset by lower yields for munis compared with similar corporate bonds. On Thursday, however, the Barclays Capital Municipal High Yield index yielded 5.8%. That's just one percentage point less than the yield on the corporate junk index; the average difference between the two yields has been three percentage points over the past five years.
Put differently, for an investor who pays 25% in federal taxes, a 5.8% municipal yield is like getting 7.7% on comparable corporate bonds--nearly a percentage point over what corporate junk bonds pay.
Junk bonds are riskier than other bonds, and therefore aren't for investors who value short-term protection of capital over long-term return potential (like many retirees). Investors who do buy junk munis should do so through funds to get as much diversification as possible, and should buy small amounts, given the higher risks.
For the lowest fees, look to index funds, which track baskets of bonds. Market Vectors High Yield Municipal Index (HYD),
For investors who wish to pay a bit more for professional bond selection, there is T. Rowe Price Tax-Free High Yield,
One last reason to consider junk munis: They may take some of the sting out of any tax increase next year, if Congress doesn't extend the temporary rates that are set to expire. Higher taxes, or even the anticipation of them, can lure investors to munis in general. This past week, says data firm Lipper, inflows into muni bond funds reached the fastest pace since March.
Investors who buy junk munis should think long-term, but the potential for a short-term boost doesn't hurt.—Jack Hough is a columnist at SmartMoney.com. Email: email@example.com