High-yield bonds, otherwise known as “junk,” are making a comeback in a market in which stocks have soared — and have subsequently seen a drop in their dividend yields — and investment-grade corporate bond yields to maturity have been compressed to low- to mid-single digits.

But junk, which had an average yield of 7.82% in mid-March, according to the FINRA/Bloomberg high-yield U.S. corporate bond index, has a yield spread of 446 basis points over the U.S. 10-year Treasury bond. That is below the historical average yield spread of 550 bps for bonds below investment-grade.

Skeptics might say that junk is pricey at these levels, but with defaults dropping to historical lows, you can make the argument that junk is offering a good return for not much risk, says Adrian Prenc, vice president of Toronto-based high-yield bond specialist Marret Asset Management Inc.

Junk bonds are expected to return 6%-7% in 2011, he notes, adding, “It will be a decent return compared with other classes of fixed-income.”

Fitch Ratings Ltd. reports that U.S. high-yield bond defaults were just 1% of outstanding high-yield issues — one of the lowest default rates on record, according to the New York-based credit-rating agency’s U.S. high-yield default index. Fitch’s report notes there were just eight default issues totalling a relatively modest US$2.5 billion in the third quarter of 2010.

A word of caution: although junk may be getting a lot of respect these days, it is still risky. On March 4, Warren Buffett’s Berkshire Hathaway Inc. reported a US$1-billion writedown on the debt of Energy Future Holdings Inc., a Dallas-based power-generation holding company, which had offered a 10% yield at the time of purchase. Even the rich and wise can get skinned in junk.

But in spite of the default risk, junk’s prices have risen by 88% since the end of 2008, according to Bloomberg LP.

The drivers in the junk market are not just appealing yields but the fear that the U.S. Federal Reserve Board has pumped up bond prices with its quantitative easing policies. That is, the Fed has bought government bonds aggressively, dragging the entire investment-grade market down along in the process. And as investment-grade yields fell, investors hungry for income moved into junk.

They have been rewarded. In the year ended Feb. 28, the median return of high-yield bond funds sold in Canada was 11.18%. Yet, performance varied widely. The top performer in those 12 months was Chou Bond Fund (US$), up by 34.83% vs a year earlier. The worst performer, Navina/Lazard U.S. High Yield Bond Fund, gained just 1.23% in the same period.@page_break@In Canada, the drive for yield has been accelerated by the elimination of preferential tax rates for income trusts. The Canadian junk bond market is not highly developed, so Canadian inves-tors shop in U.S. markets.

In the first two months of 2011, US$55.4 billion of junk was issued after a record US$287.6 billion issuance in 2010, reports Bloomberg. Recent issues include US$1.18-billion worth of seven-year senior unsecured notes, rated Ba3 by Moody’s Investors Service Inc. , from Huntington Ingalls Industries, a unit of Northrop Grumman Corp.; US$500 million of eight-year senior notes from MEMC Electronic Materials Inc., rated B-1 by Moody’s; and US$400 million of eight-year notes from J. Crew Group Inc., with a Caa1 rating by Moody’s. (B ratings have what Moody’s calls “moderate credit risk”; and the credit-rating agency calls Caa1 a “very high credit risk, with a strong implication of potential default.”)

Investors are eating up junk in spite of the red flags. But the market is selective, accepting corporate default risk in preference to sovereign risk. Ten-year Greek state bonds have recently been priced to pay 12.4% to maturity, which is 900 bps over the yields on German bunds. These high yields indicate the reluctance to buy debt that the market suggests will default or be refinanced by the issuer in a forced settlement with longer maturities and lower running yields.

The enthusiasm of retail inves-tors for corporate junk shows up in flows of funds in and out of high-yield funds and broad corporate-bond funds. For example, in February, SPDR Barclays Capital High Yield Bond ETF had inflows of US$198 million and iShares High Yield Corporate Bond ETF attracted inflows of US$246 million. In the same month, iShares Boxx Investment Grade Corporate Bond ETF experienced an outflow of US$365 million.

Given the recent strong performance of high-yield debt, is it a good time to enter the junk market? No, says Chris Kresic, partner and co-lead manager of fixed-income with Montreal-based Jarislowsky Fraser Ltd. in Toronto: “You’re in the cycle [in which] a lot of good news has been built into the valuation of high-yield bonds. My view is that we have papered over weak fundamentals in the U.S. economy, so I would argue that you want to take risk off the table rather than putting it on by buying high yield bonds.”

History justifies that caution. Ed Altman of New York University’s Stern School of Business is an expert on high-yield debt. His research has shown that high-yield default rates always rise 18 to 24 months after periods of increased issuance. The evidence is strong — the correlation is almost 100%. IE