Is it time to consider high-yield bonds again?

It just might be, if you can stomach some volatility in the months ahead. The past two weeks certainly have been no picnic. While stocks have hogged all of the recent headlines, high yield — as gauged by the iShares iBoxx $ High Yield Corporate Bond Fund ETF (NYSE:HYG) — has declined nearly 7% thus far in August. As a result, the asset class has once again become a compelling option for yield-oriented investors.

This hasn’t been the case for most of 2011. In mid-February, The BofA Merrill Lynch U.S. High Yield BB Option-Adjusted Spread — as reported on the St. Louis Fed’s website – touched a low of 339 basis points, indicating that the risk/reward profile for high yield was no longer as favorable as it had been throughout the prior two years. Now, however, the downturn in high-yield bonds — together with the collapse in Treasury yields — means that spreads are once again on the rise.

The BofA spread closed at 544 on Tuesday, compared with 395 as recently as July 27. More relevant for individual investors is that the yield on HYG was 7.84% as of Wednesday’s close, while SPDR Barclays Capital High Yield Bond ETF (NYSE:JNK) was yielding 8.03%. Comparatively, the yield on the 10-year Treasury stood at 2.14%. The current yield advantage of these ETFs relative to Treasuries, at 550-600 basis points, appears to provide adequate compensation for the added risks associated with high-yield bonds.

With the economy on a perilous footing, risk certainly is a prime consideration for investors in high yield. If the asset class were to stage a meltdown similar to that of the 2008-09, there would be quite a bit more downside from current levels. Still, consider that:

• The VIX was in the low 40s on Wednesday, a level that typically indicates that a bottom is in sight for both stocks and high-yield bonds.
• The high-yield default rate, which rose to near 15% during the crisis, currently stands below 2%. Robust earnings have led to a significant strengthening in corporate balance sheets in recent years, and many high-yield companies used the positive market environment of 2010 to refinance existing debt at much more favorable terms. As a result, a spike similar to that of 2008-09 appears to be unlikely in anything other than the absolute worst-case economic scenario.
• On Tuesday, the Federal Reserve stated that it intends to keep short-term rates near zero for at least another two years. This indicates a continuation of a policy that has favored higher-risk assets over lower-yielding alternatives. With the 10-year Treasury yield now at all-time lows, investors might have no choice but to take on added risk just to keep up with inflation.

While typically ETFs are the best way to reallocate assets quickly, a mutual fund might be a better bet right now. If defaults do indeed tick up, an actively-managed strategy that can seek to avoid torpedoes might prove more effective than the passive approach employed by ETFs. Among the no-load funds that feature strong, long-term track records are Metropolitan West High Yield Fund (MUTF:MWHYX), Fidelity Capital & Income Fund (MUTF:FAGIX), USAA High-Yield Opportunities Fund (MUTF:USHYX) and T. Rowe Price High Yield Fund (MUTF:PRHYX).

It’s true that we’re in a high-risk environment, and high yield is likely to remain volatile until the stock market begins to recover. However, the downturn of the past few weeks has created a fresh opportunity for income-oriented investors to put high-yield bonds back on their radar screens.