Junk-Bond Funds Get Trashed

It's been a rotten time to be in high-yield bonds, too. Junk bonds suffered their worst month on record in September, falling 8.3% as investors purged their portfolios of debt connected to firms with poor credit ratings.

The drop dragged down even those funds that hold mostly better grades of junk bonds, including Pax World High Yield (symbol PAXHX). The fund, which invests only in companies that pass certain social and environmental screens, got a lift, relative to its peers, by largely avoiding bonds rated triple C and lower.

With prices in a free fall, yields have rocketed to the heavens. The Merrill Lynch Master High Yield II index yielded 18% on October 10, or 14 percentage points more than ten-year Treasuries. "Now is a great time to be entering the market," says Mary Austin, manager of the Pax World fund.

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However, the road forward is anything but certain. Austin thinks the U.S. is already in a recession that will continue into 2009. But its length and severity, and by implication the number of companies that eventually default on their debt, depends on the effectiveness of various government efforts to unfreeze credit markets and jump-start the economy. Unlike past downturns, during which rising default rates have remained confined to a few sectors, the wave of bonds going sour this time may be spread across many sectors, says Austin. She's betting that debt from the consumer-staples, health-care and energy sectors will hold up the best. The fund yields 8%.