I’ll admit it; I’ve never had much interest in the bond market. A rather shocking fact that I learned early in my career is that, on average, bonds tend to be more volatile than stocks, but generally provide significantly less return. Therefore, I’ve always wondered why anyone would want to trade bonds.

Obviously there are times when investing in bonds is a no-brainer opportunity such as after the Crash of ’87, the Gulf War, 9/11, and most recently, the credit crisis. But other than these calamitous events, I just don’t understand the idea behind trading the government bond market (unless, of course, you’re doing it with tremendous leverage in the futures market).

However, as a money manager, I am forced to run portfolios that are “growth and income” oriented and as such, must own some bonds. But I’ll let you in on a little secret; more often than not, my bond positions are really “stocks in drag” -- aka high yield, or “junk” bonds.

The high yield bond market had a great year in 2009. The Lipper High Yield Bond Fund Index gained 46.38% last year, which easily beat out the vast majority of stock funds and market indices (only the emerging market areas did better). And Pimco, the largest manager of bonds on the planet, says their index of junk bonds jumped an impressive 58%, which is the biggest gain on record.

Although the outsized gains in high yield corporate bonds are unlikely to be repeated anytime soon, analysts at Pimco and Ned Davis Research look for high yields to provide solid returns again in 2010.

In Pimco’s latest report, Andrew Jessop, who runs a high-yield portfolio at Pacific Investment Management Co (Pimco), says that investors could see high yield bonds post returns in the low double digits this year. Andrew says, “We believe investors can capture attractive yields and excess spread in the high-yield market with relatively low default risk.”

Reuters suggests that high-yield bonds even look attractive compared to stocks. Their thinking is that equities depend on faster economic growth than do junk bonds at this point in the cycle. The problem is that most analysts expect economic growth in the U.S. to be sub-par (aka “below trend”) going forward. Thus, logic would dictate that from a macro perspective stocks may not have even “normal” growth opportunities for the next few years.

"In that environment, many investors believe equities could continue to underperform high-yield" bonds, Jessop says. And with an average yield of nearly 9% right now, many high yield or “junk” bonds continue to look attractive.

Mr. Jessop told Reuters that Pimco is finding opportunities in higher-quality, or double-B-rated, high-yield bonds. Jessop believe many of these companies are actually positioned to survive in a slower growth economy.

So, how does the average investor benefit from this market? The most popular approach is to buy a high yield bond fund such as Fidelity High Income Advantage (FAHYX). However, those investors that prefer ETFs (we do) may want to look into the iShares IBOXX High Yield Corporate ETF (symbol HYG) or SPDR Barclays Capital High Yield ETF (symbol JNK).

Another opportunity we are currently considering is the Pimco Corporate Opportunity Fund (PTY), which is a closed-end fixed income fund. According to the fund’s profile in Yahoo Finance, the fund invests in fixed income markets across the globe. It invests in corporate debt obligations rated in the lowest investment grade category Baa or BBB and in the highest non-investment grade category Ba or BB. The fund focuses on intermediate maturity bonds across multiple industries and sectors.

Bill Gross, co-CEO of Pimco, highlighted this fund as one his favorite investments for 2010 in the recent Barron’s Roundtable discussion.

While junk funds having done well recently, investors should understand what the risk is with these vehicles. Cutting to the chase, a sagging economy, a surge in interest rates, or some other event that causes the risk of default to rise, will all cause junk funds to fall in value. However, none of the above seems to be in the cards at this point in time.

So, if you are looking for returns that rival equities but provide you with a nice stream of income along the way, consider investing in junk bonds.

Disclosure - Mr. Moenning owns positions in securities mentioned: FAHYX, HYG

 

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