NEW YORK (CNN/Money) -
The economy is perking up and the stock market hasn't noticed. Investors have their doubts about earnings, and valuations remain alarmingly high. But another corner of Wall Street -- high yield -- seems to be slowly but surely getting its groove back.
High-yield bond funds first started rebounding in the fourth quarter of 2001, gaining a healthy 5.5 percent, according to Morningstar. They're down 0.3 percent this year as of June 18 -- not exactly a screaming bull market, but a lot better than the S&P 500, which is down 9.2 percent in the same time. And they're likely to continue to outpace stocks if the economy continues to turn around.
"Compared to everything else, high yield is doing well," said Martin Fridsom, chief high-yield strategist at Merrill Lynch.
The deep freeze in high yield
High-yield funds, also known as junk-bond funds, buy the bonds of troubled companies. They're risky because the companies may not be able to pay back the debt, defaulting on the loan in the same way you might default on your mortgage. But because of the default risk, the companies' bonds pay above-average interest.
When times are tough on Wall Street, companies default on their loans at a higher rate. Out of all of the junk bonds issued in 2001, companies failed to pay them back 9.8 percent of the time. The default rate has already passed that level this year, according to Standard & Poor's.
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At the same time, total returns have shriveled. The three-year average for the category is a loss of 1.4 percent, according to Morningstar. Over five years, it doesn't get much better, a gain of just 0.8 percent. Its worst year was 1998, with a loss of 0.1 percent.
Scott Berry, an analyst at Morningstar, attributed the poor results in recent years to a combination of factors. The fallout in the telecom sector, which had been a hotbed for high-yield issues in the late 1990s, had a terrible sting. The recession took its toll on companies, leading to more defaults. And the Sept. 11 attacks in particular hurt lower-quality high-yield bonds.
The outlook for this year
There are already signs that defaults are declining -- and they should flatten by the end of the year, Standard & Poor's said. An economic rebound will help high yield, because companies are more likely to succeed when times are good. And while a stronger economy may lead to rising interest rates, which would hurt most bonds, high-yield bonds are less sensitive to higher rates.
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Top high-yield bond funds:
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High yield is often a scary asset class for investors. But anybody with a sizeable part of his portfolio in fixed income could put a small portion -- say 5 percent to 15 percent -- in high yield to add a little spice. Or, a younger investor who is turned off by bonds in general could consider high yield.
And how do you do it? The best way to get high-yield exposure is through a mutual fund, such as the $1.6 billion Northeast Investors. (For more recommended high-yield funds, see accompanying table.) Investors are better off in a tax-deferred account because they produce a lot of income that otherwise would be taxable, Berry said.
Bruce Monrad, a manager at Northeast, said he has big positions in companies with hard assets and dependable cash flow levels in sectors such as energy, gaming and restaurants. Other holdings include Stone Container, a maker of paper bags used by supermarkets.
The fund has a high cash level now, around 20 percent of assets, and Monrad is putting money to work slowly as he searches for less-risky issues. The fund avoided the telecom fallout -- Monrad always thought the sector looked too risky -- and that's a big reason why the fund is trouncing its competitors, up 7 percent year to date, according to Morningstar.
"Compared to the stock market, we're doing better," Monrad said.
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