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The High-Yield Dilemma

Is the extra income still worth it?

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High-yield corporate-bond mutual funds have surged in popularity so far in 2011. They took in $7.0 billion in new money during the first two months of the year alone, according to Morningstar estimates, which comes close to matching the category's $7.6 billion intake during all of 2010.

But are investors too late? Some could be chasing the impressive gains junk bonds have posted in recent years. High yield took a big hit during late 2008's financial crisis when frozen credit markets and rising defaults pushed yields on these bonds above 20% and prices below $60 (on par notional value), on average. But it rebounded with a vengeance beginning in March 2009; the Barclays Capital U.S. High Yield Index gained a record 58% that year. The sector's advance slowed somewhat in 2010, but the typical high-yield fund still managed to generate a 14% gain last year, almost matching the S&P 500's performance. Capital appreciation made up a significant component of the sector's performance in both of the past two years. The average dollar price of bonds in the Barclays index rose in 2009 to $95 from $61, and then to $102 by the end of 2010.

Those heady gains are over for now. With the index's average price above $103 currently, there's very little room for prices to rise further. Many of these bonds include call features, which limit how high dollar prices can go; issuers have an incentive to call their bonds when they're trading at a premium, because it means they can issue new debt more cheaply. The sector's potential income returns also appear muted: The Barclays index's 7% yield is near the low end of its historical range. The last time the index was priced above $103 was early 2005, when it also yielded a little less than 7%. That year, the typical high-yield bond fund returned just 2.6%.

Miriam Sjoblom does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.