With interest rates still in the basement and Treasury bonds yielding next to nothing, investors have been forced to look outside the box in order to find income. For those wanting to stay within bonds, that means loading up on junk bonds and funds like the SPDR Barclays High Yield Bond ETF (JNK).

High-yield bonds have been on an absolute tear since the Great Recession and continue to rack up impressive gains. So much so that the average junk bond is now only yielding 5%. That has plenty of investors wondering whether the risk is worth the return.

The answer may come down to how you think about high-yield bonds in your portfolio. The truth is that junk could still be where it’s at for quite a while. (For related reading, see: Is The Party Over For Junk Bonds?)

Risk and Potential Reward

According to investment researcher and ratings service Morningstar Inc. (MORN), investors have already moved a cool $5.4 billion into high-yield bond funds in the first four months of 2014. That’s on top of the $3.4 billion they invested in the sector during all of 2013. All of this yield-searching has allowed the sector to return nearly 8% last year and around 5.16% year-to-date.

It’s also caused yields on the bonds issued to companies with lower creditworthiness to plummet to just 5% – well below historical norms. That has many investors worrying that the sector is now reaching overvalued territory.

While there is some validity to the argument, there still are plenty of bullish tailwinds propelling the high-yield bond sector, one of which is stable or falling default rates. (For related reading, see: Junk Bonds No Longer Junk)

Economic growth is helping companies meet their financial obligations, meaning that default rates for junk bonds are still below their historic averages. A recent report from Moody’s Investor's Service shows that junk bond default rates in the U.S. held steady at just 2.1% in May. The figure for the rest of the globe fell to 2.3% in May, down from 2.5% in April. That average default rate is still well below the 4.5% reached in the 1990s.

What About Rising Rates?

The specter of rising interest rates may not be all that detrimental to junk bonds. Due to their nature, junk has actually done quite well in the face of raising rates. According to TIAA-CREF, during prior periods of relatively moderate and steady interest rate increases, junk actually produced positive returns. Looking at the period between 1998 and 2013, of the 14 times that Treasury yields spiked, high-yield bonds produced a return of 4.99%. Regular corporate bonds returned -0.48% and Treasuries -5.53%. (For related reading, see: Junk Bonds: Everything You Need To Know)

Betting on Junk

So there’s still room for good news for junk bond investors, albeit with a grain of salt. The lesson here is to be cautiously optimistic. That means investors may want to trade out broad junk bond index funds, such as the popular iShares iBoxx $ High Yield Corporate Bond ETF (HYG) or the aforementioned JNK, for some active management. Active managers can shift through the sector and pick out the best bonds for the new environment. A prime starting point could be the AdvisorShares Peritus High Yield ETF (HYLD).

HYLD’s managers take a “value-based, active credit” approach to the sector. The fund tracks 74 different companies, with Arch Coal Inc. (ACI) and Air Canada bonds as some of its top holdings. That focus on credit and deeply valued bonds helps HYLD produce a monster 7.71% distribution yield. The only drawback is the ETF's high 1.25% expense ratio. Another option could be the PowerShares Fundamental High Yield Corp Bond (PHB), which uses screens to create an index of junk bonds on the better end of the spectrum. (For more on this topic, see: 4 High Yielding Junk Bond ETFs)

For options at the upper end of the risk spectrum there's the iShares Baa - Ba Rated Corporate Bond ETF (QLTB) and the Market Vectors Fallen Angel High Yield Bond ETF (ANGL), which buys bonds of companies that were once considered investment grade that have now slipped down to junk status. QLTB yields 4%, while ANGL yield's a hefty 5.5%.

Finally, investors have flooded the senior and floating-rate bank loan market looking for yield. Similar to junk bonds, these loans are often made to firms with less-than-stellar credit. Like the previously mentioned HYLD, the SPDR Blackstone/GSO Senior Loan ETF (SRLN) applies active management to this sector of the high-yield marketplace. SRLN's managers can then weight the risks/rewards accordingly.

The Bottom Line

Despite recent gains, junk bonds still could be a good bet for investors based on a variety of factors working in their favor, such as stable or falling default rates and improving economic conditions. The key could be focusing on quality within the space. Accordingly, a dose of active management could be just what the doctor ordered.

Related Articles
  1. Bonds & Fixed Income

    Junk Bonds: Everything You Need To Know

    Don't be fooled by the name - junk bonds may be for you if you know how to analyze them.
  2. Mutual Funds & ETFs

    Top 3 Inflation Protected Bond Mutual Funds

    Learn about the characteristics and suitability of the top inflation-protected bond mutual funds, and how investors can use these funds to their advantage.
  3. Mutual Funds & ETFs

    Top 3 High Yield Bond Mutual Funds

    Read about three high-yield bond mutual funds and why they are currently popular, and learn the advantages and disadvantages of investing in high-yield bonds.
  4. Professionals

    Are ETFs a Good Fit for 401(k) Plans?

    The popularity of ETFs among investors and advisors continues to grow. But are they a good fit for 401(k) plans?
  5. Bonds & Fixed Income

    An Assessment of High Yield Corporate Bond Credit Spreads

    A credit risk literature review.
  6. Bonds & Fixed Income

    A Guide to High Yield Corporate Bonds

    The universe of corporate high yield bonds encompasses multiple different types and structures.
  7. Bonds & Fixed Income

    A Brief History of the U.S. High Yield Bond Market

    The U.S. high-yield corporate bond market has existed for decades: it's known for its rapid growth periods as well as its risks.
  8. Mutual Funds & ETFs

    The Top Vanguard Emerging Market ETF

    Learn why growth investors should consider investing in VWO's portfolio of emerging market stocks.
  9. Investing Basics

    How to Pick the Best Muni Bonds and Muni Bond ETFs

    Municipal bonds are a good addition to a diversified portfolio as long as you choose correctly based on population and local economic trends.
  10. Retirement

    Annuities Vs. Bonds: Which One Is Better For You?

    Compare the important features of annuities and bonds, and understand which investment vehicle is the better choice based on retirement goals.
  1. What are the risks of annuities in a recession?

    Annuities come in several forms, the two most common being fixed annuities and variable annuities. During a recession, variable ... Read Full Answer >>
  2. Are high yield bonds a good investment?

    Bonds are rated according to their risk of default by independent credit rating agencies such as Moody's, Standard & ... Read Full Answer >>
  3. Do mutual funds invest only in stocks?

    Mutual funds invest in stocks, but certain types also invest in government and corporate bonds. Stocks are subject to the ... Read Full Answer >>
  4. Can mutual funds invest in IPOs?

    Mutual funds can invest in initial public offerings (IPOS). However, most mutual funds have bylaws that prevent them from ... Read Full Answer >>
  5. What are the maximum Social Security disability benefits?

    The maximum Social Security disability benefit amount for a single eligible person in 2015 is $1,165 per month, but you can ... Read Full Answer >>
  6. What is the relationship between the current yield and risk?

    The general relationship between current yield and risk is that they increase in correlation to one another. A higher current ... Read Full Answer >>

You May Also Like

Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!