High-yield corporate bonds -- or junk bonds -- offer yields that currently average around 11%. That’s a huge six percentage points more than you can earn on supersafe ten-year Treasuries.

Of course, there’s a reason junk bonds pay such mouth-watering yields. Junk bonds have suffered through nearly five years of mediocre performance. Many junk bonds were issued by financially troubled telecom companies. Some issuers have defaulted on their bonds.

But with the economy out of recession and growing at a modest pace, the rate of defaults is bound to decline, predicts Moody’s, one of the biggest bond-rating agencies.

Looking for a turnaround

"At some point, the economy does better than just barely keep its head above water, and defaults start to decline," says Ken Gregory, president of No-Load Fund Analyst newsletter. He expects that to happen in the next 12 to 18 months.

Steve Leuthold of the Leuthold Group, a Minneapolis-based investment research firm, recommends junk bonds. “The time to buy high-yield bonds is after a recession,” he says. “As the economy strengthens and profits improve, the default rate begins to recede and high-yield bonds outperform high-quality corporates.”

In a strengthening economy, junk bond prices rise (and yields fall, since prices move inversely to yields) and total returns increase. Even assuming defaults of 8% to 9% over the next two years and a fall in junk-bond interest rates from 11% to 10%, a junk bond portfolio should return an annualized return (which includes price appreciation and yield) of 7% to 10% over those two years.

If defaults fall further, which seems likely, you could make a lot more from junk bonds.

How to invest

Don’t try this at home. Finding junk bonds that will eventually pay off is a task to leave to experienced managers. You need a widely diversified portfolio of bonds to cushion yourself from inevitable defaults.

One of the most attractive junk bond funds is Northeast Investors Trust (NTHEX). This fund has been run by Ernest Monrad since 1960. His son, Bruce Monrad, signed on as co-manager in 1993.

Janus High Yield (FAGIX), managed by David Glancy, are two other attractive choices. Another solid fund is Strong High Yield Bond (STHYX), whose manager is Jeffrey Koch. The lead managers of all three funds have been on the job for six years.

Don’t make the mistake of shopping the leaders’ lists among junk funds over the past three or five years. The funds that have done the best are those that have taken the fewest risks. That’s not the kind of fund you want now.

And finally: Don’t go overboard. Limit junk bond funds to no more than one-quarter of your total bond investments. Junk bonds offer the potential for good returns, but they are almost as risky as stocks.

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