Dumpster Diving For Junk Bonds

If Michael Milken was to be given the opportunity to handle securities again, he would be smiling. The junk bonds he helped make famous now pay outrageous amounts. Ten-year, government-sponsored Treasury bonds currently yield around 2.25%, while similar junk bonds yield about 20%. Usually, the spread between the two is only around 400 basis points.

Junk bonds essentially are an IOU issued by corporations with bond ratings at or below a BB rating from Standard and Poor's or a Baa rating from Moody's. Typically, these bonds have higher coupon rates because the companies that issue them often have weaker balance sheets. The current marketplace, plagued by economic uncertainty, has driven prices for these securities downward, while it has pushed yields upward. Currently, default rates on these "junk" securities hover near 3%. However, some analysts predict that rates could rise to 10% or more. (To learn more about creating a balanced portfolio, be sure to read 20 Tools For Building Up Your Portfolio.)

Although the country is not expected to see Great Depression-style defaults and bankruptcies, it pays to spread around risk anyway. While your portfolio may benefit from a high quality, active mutual fund, the exchange-traded fund (ETF) market offers lower expenses and broader diversification.

3 ETF Picks
The largest of the funds, with more than $2 billion in assets, comes from Barclays iShares. The iBoxx High Yield Corporate Bond Fund (NYSE:HYG) provides investors a broad group of 53 holdings, including a cash position. Issuer variety is key for these higher risk funds. The largest allocation to any one sector claims only 12.7%, in healthcare services and equipment. Credit quality is good, with a B1/B+ weight, which puts the average in the middle of the high yield marketplace. Expenses total an inexpensive 0.50% annually. (Learn how to determine a fund's risk-return profile by reading Evaluating Bond Funds: Keeping It Simple.)

For investors willing to move slightly down the quality ladder to a B2 weighting, State Street offers the SPDR Barclays Capital High Yield Bond ETF (NYSE:JNK). The fund follows an index designed by the former Lehman Brothers and tracks high yield corporations with the highest liquidity. Therefore, the fund is concentrated into a few sectors and accounts for an 80% weighting in industrial companies. The high focus in industrials should not be seen as a cause for concern because the fund spreads its $850 million in assets among 101 different holdings. However, the fund offers investors a higher distribution of 14% to help offset the sector weighting. Expenses and management fees total 0.40% annually.

The smallest of the funds in terms of assets under management and shares available comes from Invesco's PowerShares. With only $39 million in assets and 3.2 million shares outstanding, the PowerShares High Yield Corporate Bond (NYSE:PHB) follows a theoretical portfolio created by Wachovia Securities. This bonds portfolio resets quarterly. With a total of 54 holdings, the fund includes a nearly 2.4% emphasis in the Barclays iBoxx Fund (HYG), which essentially creates a double weighting in many of same bonds as the PowerShares fund. Thus, the bonds shared with Barclay's iBoxx forms a bit of double-dipping on fees, which explains why the fund is not as popular as the other two, better diversified, ETFs. The PowerShares Corporate Bond yields 13.11% and charges 0.50% in expenses annually.

Other Choices
Unfortunately, Vanguard does not yet a high yield Viper exchange-traded fund, as the company's ETFs are among the cheapest in the industry according to annual expenses. However, companies such as PIMCO (PIMCO High Income (NYSE:PHK)), Black Rock (BlackRock High Income Shares (NYSE:HIS)) and T. Rowe Price (New America High Income (NYSE:HYB)) offer many closed-end funds. These junk bonds offer higher yields, but come with hefty leverage. Therefore, they would be useful as a supplement to the index ETFs listed above. (Take a closer look at closed-end funds in Open Your Eyes to Closed-End Funds.)

Bottom Line
Uncertainty for the future as a result of the current economic mess has driven the spreads between high quality Treasury bonds and lower quality junk bonds to unheard of levels. While anything can happen, investors willing to spread risk in this sector will be rewarded when conditions return to normal. The preceding exchange-traded funds offer a smart way for investors to become their own "Junk Bond King" or "Junk Bond Queen". (Read more in Bond Spreads: A Leading Indicator For Forex.)