Now May Be the Best Time for These Double-Digit Yielders

If this article were a movie, then it would be rated “M” for mature. This investment isn’t for the faint of heart.

But if you can stomach a little volatility in search of higher yields, then I would be remiss if I didn’t bring your attention to this opportunity. With these securities, yields of 10% or more aren’t just common, they’re often expected.

#-ad_banner-#What investment am I talking about?

Junk bonds, but more specifically, junk-bond funds.

Junk bonds are corporate bonds that are rated below “investment grade” (BBB- on the Standard & Poor’s rating scale). But don’t let the “junk” in their name fool you. Though riskier than investment-grade bonds, junk bonds can still offer a good high-yield opportunity with low-default rates.

I last suggested junk bonds about two years ago, when I added SPDR Barclays Capital High Yield Bond (NYSE: JNK) to my High-Yield Investing “10%-Plus” model portfolio.

At the time, the investment was a no-brainer. This exchange traded fund (ETF) was yielding 12.8%. Corporate default rates — a key driver of junk-bond prices — were rapidly declining as the economy recovered.

Meanwhile, junk bond yields were trading at a huge 9% premium to Treasury yields (meaning the spread between similar Treasury yields and these bonds was nine percentage points).

The historic average for the yield spread between Treasuries and these high-yield bonds is close to 6%. If the spread is above that, then junk bonds are considered cheap.

Subscribers and I were rewarded for taking the risk. In about two years, we’ve received $7.87 per share in distributions. Although JNK has pulled back slightly from a recent peak of $41 this May, we’ve still enjoyed total returns of over 25%.

So naturally, I’ve been looking for a good time to add more junk-bond exposure to my portfolio. But by February of this year, the spread between these bonds and Treasuries was hovering about 4.5% — a little on the pricey side.

But thanks to an S&P credit downgrade of the United States and a European debt crisis, the landscape for these high-yielders has shifted.

As the market sold off, risk-averse investors pulled their money out of junk bonds and junk bond funds. That’s put all types of these securities on sale, pushing the yield spread above 7%.

Now that junk bonds are affordable, I think it’s reasonable to believe investors will return to these high-yielding investments.

For one reason, investors are starved for higher yields.

An ironic consequence of the S&P’s ratings cut was that investors stampeded into the recently downgraded Treasuries for safety, causing the yields on these assets to plummet.

Five-year Treasuries are currently yielding a paltry 0.9%. Meanwhile, 5-year “AAA” corporate bonds aren’t any more appealing, yielding slightly more than 1.3%. When the panic abates, investors could return to the junk bond arena, desperate for higher yields.

But higher yields aren’t the only allure.

Right now, corporations are sitting on piles of cash, a good sign for corporate solvency. During the peak of the credit crisis in November 2009, the U.S. junk-bond default rate peaked at 13.7%. But by July 2011, corporate default rates were near 1.3%. That’s well below the long-term 5.1% average.

And despite the recent financial panic, default rates are predicted to stay down. “Corporate default counts have remained low, consistent with our recent expectations, and under our baseline economic scenario of slow recovery, we expect that trend to continue,” says Moody’s director of credit policy Albert Metz.

Therefore, assuming corporate default rates stay low, the economic back-drop bodes well for a rebound in this sector.

Like I said, junk bonds aren’t for everyone. There’s an element of risk that naturally comes with investing in a speculative bond market.

Action to Take –> But looking forward, the market for junk bonds looks strong. And if the current environment has you hunting for higher yields, then these securities could be just the thing.

P.S. — In my last issue of High-Yield Investing, I talked more about junk bonds and suggested two high-yield bond funds yielding 10.4% and 11.1%, respectively. To learn more about this advisory, which is enjoyed by nearly 40,000 subscribers, I invite you to watch this presentation…