Junk Bonds: A Rickety Recovery

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"But that puts people on edge and makes them ready to sell and get more defensive," says Larkin. However much investors may appreciate the returns they're getting from high-yield bonds, they want to lock in the gains from the first part of this year, he adds.

How Big an Increase in Defaults?

Larkin believes the steeper default rate has already been priced into many of the high-yield market valuations. The information companies disclose during earnings season will help investors get a handle on what the future may hold for the economy. Lack of future earnings guidance by companies won't be taken well. In the financial sector, for instance, which has reported so many asset writedowns up until now, if investors get more disappointments, they're likely to lose patience in that sector, he says.

One factor that may influence the direction of spreads more than earnings will probably be how much defaults increase over the next six months, says Manny Labrinos, portfolio manager of the Nuveen High Yield Bond Fund (NHYRX) in Los Angeles. His fund was up 17.6% year-to-date as of July 7, after losing 24.7% of its value in 2008.

Default expectations have dropped with improvement in the market "because a lot of companies that ordinarily would have hit a wall have been able to come to market [with new issues and refinance] some of their short-term maturities," he says.

While spreads for high-yield bonds are still fairly wide compared with historical levels, "clearly some of the extreme undervaluation in the asset class has been removed because of market appreciation," says Scott Kubie, a portfolio manager at CLS Investments in Omaha. He admits to having slowly reduced some of his portfolio's allocation to high-yield exchange-traded funds, and says he'd be more eager to trim his exposure if he could find other asset classes offering comparable returns and that are more cheaply priced. He thinks the default rate could rise to roughly 12% in the future.

Larkin at Cabot and Kubie both use the iShares iBoxx $ High Yield Corporate Bond (HYG) and the SPDR Barclays Capital High Yield Bond (JNK) ETFs for their high-yield allocation.

Now, "A More Ordinary Credit Recession"

Nuveen's Labrinos sees the high-yield market as "relatively bifurcated for now." The bonds issued by companies the market believes will survive have already rallied to trade at up to 90¢ on the dollar, while the bonds of more distressed outfits are still languishing at 20¢ or 30¢ on the dollar in some cases. The latter group is where he expects most of the defaults to come from, particularly in the media and entertainment sector, where companies tend to carry some of the highest debt loads and where advertising revenues have been so damaged by the recession.

"We went from a major financial crisis and liquidity crisis to a more ordinary credit recession," Labrinos says. "High-yield investors, generally speaking, are more comfortable dealing with that kind of environment and it becomes more an issue of returning to fundamentals and doing recovery analysis and liquidity analysis and figuring out who's going to hit a liquidity wall."

The long-awaited rollout of the Public Private Investment Partnerhsip (PPIP), albeit at a much lower-than-expected investment level of up to $30 billion by the U.S. Treasury, could provide investors still looking for higher returns with an alternative to high-yield bonds. Larkin believes the illiquid assets that private investors will be buying off banks' balance sheets will "offer very compelling yields and may be a good component to a high-yield strategy for retail investors." He says he's interested in who will create the first fund that packages these securities in a way that they are more attractive to retail investors, which he expects to happen by this fall.

Labrinos says he thinks the PPIP assets will appeal to a different kind of investor than those who buy high-yield bonds—financial firms and hedge funds, as opposed to mutual fund and pension fund managers.

With so much uncertainty surrounding the recovery—and the pace of defaults by speculative-grade issuers—expect high-yield investors to remain on the sidelines for the foreseeable future.

Bogoslaw is a reporter for BusinessWeek's Investing channel.

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