Editor's Note: Aware that high-yield bonds generally start to appreciate at some point before a weak economy starts to strengthen, we decided to tap the views of Benjamin Trosky, portfolio manager of PIMCO High-Yield Institutional (PHYX). Trosky has managed the fund since its inception in December 1992, achieving an annualized return of 9.1%, compared with the Morningstar high-yield category return of 6.35%. Given PIMCO's assessment of current valuations and lackluster economic outlook, Trosky believes it's still too early for most investors to add to their high-yield allocations. But he offers some interesting insights about how he's positioning his portfolio in light of certain unusual credit-rating spreads.

hat is the "normal" allocation to high-yield that you recommend within clients' fixed-income portfolios, and what are you currently recommending?

I'd say that you probably put your top limitation at 10% of a fixed-income portfolio. But right now, the house view is that 2% to 3% is about right. Our thinking is that if the market softens up and net-asset values decline, we would then actively work to build a larger strategic allocation.

So you're recommending less than half the normal exposure to high yield. Why?

PIMCO's view is that we should remain in a defensive position. As a firm, we believe that the consumer has spent well in excess of income for an unsustainable period of time. Also, we don't believe that capital spending, which was a significant driver of the long expansion, will be able to pull us out of this slump over the next year.

Higher energy prices are taking their toll, the dotcom craze is still being digested, and there are broad sectors of the economy that still have excess capacity. In addition, potential volatility in the dollar would likely translate into increased volatility in the "spread" sectors.

Aren't the spreads between high yield and Treasuries pretty wide right now?

You can make the argument that the high-yield indices offer a very wide spread over Treasury yields. But what the indices are hiding is the most bifurcated market that I've ever seen. On the one hand, there's been an extraordinary flight to quality, as shown by the bidding up of BB rated bonds. At the same time, the spread between single-B issues and Treasuries is very wide by historic norms, partly because the B credit rating includes a significant component of distressed issues with spreads of more than 1,000 basis points above Treasuries.

But what happens is when these distressed issues default, they get dropped from the index. So while enticing, especially in a low interest-rate environment, the yields can be a bit ephemeral and do not necessarily translate into total return.

Are you saying that yields on high-yield indices currently are distorted on the high side?

Yes, part of that yield component is illusory because a number of the issues with 25% yields to maturity are going to default and will disappear from the index.

What is the current default rate and how does that compare with longer-term averages?

Depending on which source you're using, the default rate currently is somewhere between 7.5% and 9%, and we think it's going to stay at this kind of level for at least the next year. Longer-term averages are in the 2% to 3% range.

How are you positioning your portfolio in light of this environment and these distortions?

As you know, our fund is generally positioned with a bigger component of higher-quality junk than the category average. Our average quality through time is in the middle to lower end of the BB-rating category. Currently, the portfolio is positioned even more defensively than usual. Our average quality is running higher than its traditional range, and we're running a duration that is lower than usual.

Given the bifurcation within the high-yield market, our strategy is to use a credit barbell. At the high end, we are hiding in secured bank loans where we've got about a 6% weighting. In addition, we added to our investment-grade exposure and decreased our BB holdings. Since the BB-rated issues have been bid up so much, you can move out of them and into the higher-quality BBBs without giving up much in yield.

What about the lower-quality end of the barbell?

We have selectively held and added to some of the single B's that we thought got very carried away on the downside, including some of the telecom issues where we've maintained about a 10% weighting. I think that the risk-return tradeoff in that area is very attractive and that you can find significant value because there's been such a dramatic flight from that sector.

Take Level 3 Communications, for example. This company has $3.5 billion in cash-I've never seen a company go bankrupt with $3.5 billion in cash. Although it's rallied significantly, it's still yielding somewhere around 19% [as of mid-August].

Do any other industries besides telecom offer good value?

The cable industry has a number of companies with critical mass that are continuing to add higher-revenue subscribers using digital services. An example here is Charter Communications, which has done a very nice job with digital services. The bond offers a 10% yield in a 5% world, which I think is very attractive. In addition, there are still some good buys in the infrastructure area of energy production, where there's a secular lack of capacity.

What's your approach for analyzing issues?

Our approach is bottom-up, credit by credit. We try to determine what we can make versus what we can lose. If we lose, we want to know how severe it could be. In short, our process is value-oriented and driven by fundamentals.

What's PIMCO's outlook for equities?

We think it's possible that the stock market could continue to correct or go sideways for three to four years and simply bore everyone to death. We're just not that sanguine about the possibility of either strong earnings growth or P/E expansion at this point. In all likelihood, the broad-based equity market will generate returns in the mid to high single digits through the remainder of the decade.

In that scenario, we don't see much point in incurring much equity market volatility. To me, that becomes the allure of the high-yield market, and particularly the higher-quality sector. Our portfolio is positioned defensively so that it can withstand a prolonged weak economic environment. But it offers a 9% plus yield, compared to higher-quality alternatives that yield under 6% for fixed income and less than 2% for equities.

I'm still wondering why you're recommending such a small commitment to high yield.

Because I'm a coward. A lot of the market-timer money has moved back into the high-yield market, and that has pushed prices up. The trader side of me says that market-timer money also leaves quickly, and I'd rather be increasing my exposure when there are more sellers than buyers.

You were asking about junk allocation within a fixed-income portfolio, and I answered with under 5%. But I would also suggest that you allocate about 5% of your traditional equity allocation to high yield, given our outlook for equities.

Since your portfolio has more higher-quality holdings than the average high-yield fund, you hold up better than average when high yield is suffering, such as during the Asian crisis. But aren't your returns also muted when high yield is flourishing?

That's true, but we're more concerned about absolute returns than relative returns. I'm willing to lag somewhat in an up market in order to have a portfolio that won't go through zero in a difficult market. We registered positive returns in 1994 and in 1998 when the broad high-yield market had losses. And last year, we were essentially flat, before fees, in a market that was down 7% to 8%.

The problem with the lower tier of the high-yield market is its extreme volatility. During most of the 1990s, until 1997, this lower-quality sector dramatically outperformed the upper tier of the market. But if you're not able to time your exits and entries accurately, you'll end up compounding unacceptably low returns. As a speculator or trader, you want to look at some of the most beaten-down stuff you can find. But I don't think it's appropriate for the long-term strategic portfolio.

Will there be a time when you'll start increasing your single-B exposure further?

I'll become more interested when BB spreads widen out and take better quality single-B spreads with them. In that scenario, I would be increasing my single-B exposure before strength in the economy is readily apparent. We need to have a few covers of financial magazines shouting how dumb high-yield investing is. That would help shake out the weak holders and widen the spreads on the kind of credits we care about, thus making valuations more compelling. I would just love that.

Sorry that we're not more accommodating, Ben. Thanks for your time.

Mimi Lord, CFA, CFP, is senior editor of MorningstarAdvisor.com. PIMCO is a participant in the site's Due Diligence Center.