Yield-hungry investors have a tempting target in investment-grade corporate bonds, exemplified by iShares iBoxx $ Investment Grade Corporate Bond Fund (LQD). This baby was thrown out with the subprime bathwater this summer, and the market's mistake is our opportunity.

High-quality private-sector debt is one of the three main pillars of the bond market, along with government and mortgage bonds. This total market is represented by a companion portfolio, iShares Lehman Aggregate Bond Fund (AGG).

As the chart below shows, gilt-edged corporate bonds offer higher returns than their other high-quality brethren because, obviously, they involve additional risk—credit risk unique to each borrower and each issue. These risks are real, but over time, bondholders are compensated; over the last several years iBoxx LQD has outperformed Lehman Agg AGG by about two-thirds of a percentage point annually. In the low single-digit realm of bond returns, that's a lot.

This year, however, has been as topsy-turvy for bonds as for everything else. Two viruses infected the corporate debt market in recent years. The first was a financial shell game built up around wolfish subprime mortgage loans in sheep-like, high-rated packages called collateralized debt obligations, or CDOs. The second was the proliferation of dubious corporate buyouts, also packaged prettily but with sinister underpinnings.

Credit standards had been so lax for so long that the bond market was flooded with deals called "covenant-lite," or cov-lite for short. That means deals that lack certain covenants to protect lenders and that instead favor borrowers. For example, one standard covenant traditionally attached to corporate bonds was a "change of control" indenture. If a leveraged buyout would drag the quality of a bond to below investment grade, bondholders could force the issuer to buy them back for 101 cents on the dollar. In cov-lite deals, those indentures disappeared, making the bonds much less valuable.

But it was the CDOs that got bond investors into the deepest trouble. Investment banks sliced private-sector debt, including those famous subprime mortgages, into filets that shifted various risks hither and yon. For example, the first month's payment on all the underlying loans might form one packet, called a tranche, and since it was much more likely to pay off than tranches 10 years out, it got a top credit rating.

But the credit agencies never imagined the entire mortgage market could seize up virtually overnight. It did, and CDOs suddenly became toxic. It will take years for the entire mortgage mess to unravel. And a lot of corporate acquisitions contemplated on easy terms early this year are getting done on much tougher terms, or not at all.

So it's no surprise that corporate bonds took a thumping this summer, especially the junk bonds owned by iShares iBoxx $ High Yield Corporate Bond (HYG), which have more exposure to all the rot inside the credit world. You can see the evidence in the chart below.

But then a surprising thing happened. Junk bonds rebounded and by the end of September completely erased their summer weakness. But high-quality corporates did not. They remain below where they were in the spring, and below the market itself.

Momentum investors would interpret these moves to mean exactly the opposite of what I believe. They would describe the junk move as strong relative strength, and would bet it bodes well for the immediate future. They would disdain investment-grade corporates because of their weak relative strength.

My view is that junk bonds are greatly overpriced. Despite this summer's turbulence, junk bonds are only yielding about three percentage points more than Treasurys of comparable maturity. More usually the spread is 4.5 percentage points, and it can widen to 8.5 points. With very little good news likely in the junk market for the foreseeable future, I think it will likely underperform in the next year. Companies that issue junk tend to be those most closely tied to the business cycle—think the auto industry. The economy is clearly weakening—the Federal Reserve cut interest rates in September to combat that—and that means economically sensitive companies will suffer falling earnings and more difficulty servicing their debt.

High-quality corporates are issued by companies with steadier earnings not closely tied to the business cycle. The iBoxx LQD fund owns names like General Electric and FPL Group. The same trends that will benefit big-company growth stocks will benefit their debt as well.

And high-quality bonds have not recovered from their summer weakness. More than $300 billion in proposed corporate buyouts remain in the pipeline, so issuance has been unsettled, and investors are alarmed. The result: The bonds are on sale. Meanwhile, the iBoxx LQD fund is yielding 5.56%, more than half a point more than the 4.99% yield on Lehman Agg AGG. Especially with short-term interest rates on T-bills and money markets shrinking, this is a very attractive value.

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