Dealers in high-yield bonds would rather people not refer to their product as “junk.” But despite this mostly warranted name, bonds with credit ratings below the lowest investment grade of BBB have been flying high.

In the U.S., which is the main market for junk, even very questionable bonds — those rated CCC or lower by Standard & Poor’s Corp. — have risen 33% in price year-to-date as of Nov. 15, 2006. And total gains for all bonds rated below investment grade were up 8.6% in 2006.

The reason for this is that defaults are down; just 21 borrowers failed to pay on US$7 billion worth of bonds year-to-date as of Nov. 15, compared with 28 defaults on US$20 billion worth during the same period in the year prior, according to Moody’s Investors Service Inc.

Only 0.4% of bonds are in default, the lowest rate since 1998. Junk, it seems, has gotten to be downright respectable. And it may also be attractive to investors in income trusts who are looking for new ways to generate income.

The current trend to put cash into trash flies in the face of the historical default rate. Ten years after issue, a third of Canadian bonds rated CCC — which is close to the bottom of the ratings scale — default on interest or principal. And the default rate in the U.S. is an astonishing 56.5% on 10-year-old bonds. These are wretched long-term odds, but investors in low-grade corporate debt are betting that, for now, the combination of reduced risk and yields above those available on investment-grade debt are in their favour.

A good example is resources company Sherritt International Corp.’s 7.875% bond, due Nov. 26, 2012. Recently priced to yield 6.75% to maturity, it pays almost twice the 3.93% yield to maturity on a Government of Canada bond due June 1, 2012. The Sherritt bond carries a BB+ rating, slightly below investment grade. Sherritt has some operations in Cuba and the $275 million issue is small. Sherritt’s stock is up, propelled by high world commodity prices.

Another example is Paramount Resources Ltd.’s 8.5% bond, due Jan. 31, 2013. Recently priced to yield 8.54% to maturity, it carries a dismal CCC rating. But Paramount’s stock — recently priced at $24.50, although down from $50 April highs as world energy prices have declined — is up a great deal from $10 in the summer of 2005.

In spite of the currently hot performance of high-yield bonds, the sector is far more volatile than investment-grade bonds. But as Barry Allan, president of Marret Asset Management Inc. in Toronto, notes, high-yield bonds trade very differently from investment-grade debt. “The rising interest rates that cause government bonds to fall in price are associated with improving economic conditions that are good for junk,” he says.

Just how good times are for high-yield debt can be seen in the Merrill Lynch U.S. master II high-yield index, the principal measure of junk bond prices in the U.S. Spreads are currently at 306 basis points over yields for U.S. Treasury bonds. In 2002, at the nadir of the tech meltdown, yields were at 1,100 bps over U.S. Treasury debt.

“We are closer to the low for high-yield debt,” Allan says. “That was 270 bps in February 2005. There is more risk of spreads widening than shrinking. And it is certain that the next 300 bps move will be up, not down. But the present spread at 306 bps is only relevant to the risk. The default rate is down to record lows, and spreads are still above the lows.”

With high-yield bond prices at relatively high levels, the question has to be asked: is it wise to jump into junk bonds or funds of junk right now?

Allan argues that it still makes sense to buy. First, there is the recovery rate on bond defaults. That’s 50%-60% of outstanding sums due, he says. Apply that to the low default rate and there is apparent value. He argues that the investor can expect returns of 8%-9% by the end of 2007. After that, the business cycle could turn down, yield spreads are likely to widen and buyers who came late to the party will be treated to a bath of red ink.

@page_break@However, inves-tors and advisors who want to buy into high-yield bonds face tough hurdles: junk tends to be illiquid, and there is also the need to spread risk.

“You need 25 to 30 names in junk to get diversification,” says Chris Kresic, senior vice president for investments at Mackenzie Financial Corp. in Toronto, who manages a $4-billion debt portfolio, including high-yield bonds.

What a good manager can do is apparent in the record of Northwest Specialty High Yield Bond Fund, which is managed by Deans Knight Capital Management Ltd. principal Doug Knight in Vancouver. The fund, arguably the best in breed for long-term performance, produced a 7.4% average annual compound return for the decade ended Sept. 30, 2006 — well above the 5.5% average annual compound return of conventional, investment-grade bonds funds in the same period. The Northwest portfolio posted returns as high as 18.7% in 2003 and lost value in only two years, shedding exactly 2.5% in each of 1999 and 2001.

The junk investor would be wise to use a professional manager in this difficult market. It is tempting to shop for good names with bad ratings, for a Dominion Bond Rating Service Ltd. report published earlier this year entitled Corporate Default Study points out that there have been only 27 bond defaults in Canada since 1977. In most, bondholders wound up with large amounts of stock, adds Allan.

The sector’s recent record is deceptive, however. As DBRS points out in its report: “Default patterns demonstrate a few years with no defaults, followed by a concentrated period of multiple defaults.”

To play in this field, it takes fortitude for the periods in which defaults rise. And an advisor or manager must be able to separate good junk — the issues with prospects for survival and profit — from the awful stuff that deserves the dismal ratings that define the junk market. IE