Investors have been avoiding riskier parts of the credit market for most of 2008 as concern mounts about inflation and a slowing economy.

High-yield bond exchange-traded funds have been especially hard hit. For example, the iShares iBoxx High-Yield Corporate Bond ETF (AMEX: HYG) was down 1.2% this year heading into Wednesday. That compared to a 0.39% rise by the total bond market ETF iShares Lehman Aggregate Bond index (NYSE Arca: AGG).

The performance of high-yield bonds, or junk, also lags investment-grade corporate issues. The most popular of those higher-grade ETFs is the iShares iBoxx Investment Grade Corporate Bond index (NYSE Arca: LQD). Its returns were down 0.75% in 2008.

But such underperformance by junk bonds reflects a trend that began last spring when credit markets started feeling the impact of a meltdown in mortgages. In fact, junk bond funds have been doing better against their rivals lately as investors start to bottom-fish.

In the week of June 5-12, HYG gained 0.50% while AGG fell 0.71%. That period started the trading day before oil made a nearly $11-a-barrel jump on June 6 and disappointing economic data pointed to rising unemployment numbers.

"Earlier this year, Treasuries were the big outperformers," said Phil Fang, a fixed-income portfolio manager at Invesco PowerShares. "Within the past month, that trend has really started changing."

Simply put, in good times and bad, junk bonds are a different breed of bond ETF. That makes them a favorite of long-term asset allocators. And lately, some portfolio managers are arguing that an extended sell-off makes junk more attractive as a diversification tools these days.

Allocation Decisions

"High-yield bonds are a really interesting allocation decision right now," said Thomas Anderson, research director at State Street Global Advisors. "If you look at fixed income, Treasuries have been really overbought for most of this year."

SSgA came out with its own junk bond ETF at the end of last year. The SPDR Lehman High Yield Bond (AMEX: JNK) has lost just shy of 2% this year. Since coming on the market in December 2007, JNK has attracted $405.78 million in assets - all but about $18 million coming in the first half of this year.

The third competitor in the field is the Invesco PowerShares High Yield Corporate Bond ETF (AMEX: PHB). It also launched in December 2007 and has about $14 million in assets.

HYG is the oldest in the group at 14 months. With a nearly eight-month jump on its other two rivals, the ETF has garnered a sizable asset lead at $797.3 million.

"A year ago, investors weren't getting paid a ton more than Treasuries for taking more credit risk with high-yield bonds," Anderson said, noting that in mid-2007, junk bond funds were yielding around 7%.

Since then, an eight-month rush to quality by investors fleeing to Treasuries sent high-yield bond prices tumbling. At the same time, funds focused on junk took advantage as income streams took off.

"That's why the spread has widened [between junk and Treasuries]," Anderson said. "If you're looking at yield, there's just not many other places to go in today's market than high-yield bonds."

Advisor J.D. Steinhilber agrees. But the Nashville, Tenn.-based portfolio manager is still not ready to take a leap of faith on junk-bond ETFs yet. "They've definitely come back on my radar screen," Steinhilber said. "But I'd like to see their yields above 10% before shifting any allocations."

And he isn't alone. Several other advisors say they're taking a wait-and-see attitude, preferring to get a better feel for how much more of a slump the U.S. economy might be facing.

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