Time to Toss Junk-Bond Funds?

They have been the income-producer of last resort for a year now, offering investors much better returns than the typical savings accounts or ho-hum dividend stocks. But with yields on high-yield bonds hitting historic lows, even pros in the business are starting to ask: should these bonds be a part of an investor's portfolio?

After a two-year, unprecedented bull run, the average yield on high-yield (or junk) bonds hit 6.8%, according to the Merrill Lynch High Yield Master II Index, marking a new low after a two-year unprecedented run for the riskiest corporate debt. Investor demand has pushed up the prices on high-yield bonds, which has caused yields to plummet. But compared to the rest of the fixed-income market, junk bonds still look appealing. The average yield on all investment grade corporate bonds is 4.9% and 10-year Treasury bonds are yielding just 3.6%, according to Standard & Poor's Global Fixed Income Research.

In spite of the recent slide, investors have poured money into junk-bond funds. In January, high-yield funds attracted $4.2 billion in new money, an increase of 250% compared to a year ago, making them the second most-popular taxable bond funds behind bank-loan funds, according to Morningstar. Over the past 12-months, $11.5 billion flowed into these funds, less than in 2009, but still double the year before.

This may not be simply performance-chasers who are late to the party. Junk bonds may have some life in them yet, advisers say: Such bonds tend to perform well in an improving economy as lower-rated companies become better able to pay their debts. Moody's predicts the default rate on such bonds will drop this year to 1.6%, from 3.0% in January. Advisers also say the slight yield advantage, plus interest income, is worth the extra risks right now.

As a result, many are adding, not cutting back on high-yield bonds. Jim Iredale, manager of fixed income investments for Ronald Blue & Co, which manages $5 billion, says the firm has increased allocations to high-yield bonds over the past year and cut back exposure to Treasurys. Elizabeth Fell, a fixed-income strategist at Barclays Wealth, says that for clients with a moderate risk tolerance, she is allocating about 6% of their portfolios to high-yield and emerging-market bonds. "We don't think there's any emergency reason to make any changes today."

Of course, junk bonds have their detractors. Since they are issued by lower-grade companies, investors face greater default risk than they do when with investment grade bonds. And as the yield spread over safer bonds like Treasurys diminishes, holding junk bonds becomes less worth the risk. Tom Higgins, global macro strategist for Standish, began cutting back his client's allocation to high-yield bonds significantly this month after the spread over Treasurys tightened to about 4.5 percentage points, a mark he wasn't expecting to see until June. Joseph Welsh, manager of the Oppenheimer Champion Income Fund ( OCHBX ) , says investors should think twice about putting money into high-yield bond funds once the yield spread over safer bonds, such as Treasurys, gets within 3.5 percentage points. High-yield bonds are currently paying about 420 basis points, or 4.2 percentage points, more than comparably dated Treasurys, according to data from Moody's Investors Service.

For those still looking to invest in a junk-bond fund, experts recommend seeking out bond funds with an expense ratio that's less than the 1.2% average charged on high yield bond funds, with a strong track record of performance and stable management, says Todd Rosenbluth, a mutual fund analyst for S&P Equity Research. He says some of the stronger funds in the category include the T. Rowe Price High Yield Fund ( PRHYX ) , which has earned an average 11.6% over the past three years and charges .76% or $76 for every $10,000 invested. The Janus High Yield Fund ( JAHYX ) has earned 10.9% on average over the past three years and charges .94% or $94 for every $10,000 invested. And the Fidelity High Income Fund ( SPHIX ) has earned an average 11.7% over the past three years and charges .75% or $75 for every $10,0000 invested.