Junk Bonds: Ticket to a Higher Yield

Looking for solid returns that weather interest rate fluctuations?

For investors with a greater appetite for risk, high-yield corporate bond funds are one possibility. The yield is the draw, hovering around 7% versus 1.7% for a five-year certificate of deposit in early April 2011, according to Bloomberg Businessweek and Bankrate's Interest Rate Roundup. Also known as junk bonds because they have lower ratings than investment-grade bonds, their higher interest rates come with more risk of defaulting.

Conversely, the high rate also protects your investment when interest rates rise and bond prices fall, as the economy chugs along. Why? As corporate balance sheets strengthen, stocks do well and so do high-yield corporate bonds.

High-yield corporate bond funds have low volatility and good long-term returns. The reason: Historically, junk bonds offer higher yields than comparable Treasuries.

"Essentially, they're hybrid securities," says Shane Shepherd, head of fixed-income research at Research Affiliates in Newport Beach, Calif. "If 2011 is a reasonably good year for the economy, high-yield bond funds will do well."

Take the Higher-Rate Cushion

Conversely, other fixed-income investments are usually clobbered by rising interest rates because they don't have the higher-rate cushion.

The biggest risk is credit-related. Junk bonds usually have poor credit ratings of "BB" or lower versus higher-rated, investment-grade bonds, according to investment researcher Morningstar Inc. So, they're more likely to default than investment-grade bonds.

Corporate bond default rates now are typically only 2% to 3% annually, says Andrew Gogerty, senior mutual fund analyst at Morningstar. "During the crisis, they were 10%," he says.

Still, their return is better. From 1987 to 2006, high-yield corporate bonds had only one negative year for total return, compared to three for investment-grade bonds, according to an analysis by the financial magazine, Investment News. The higher-yield cushions return when interest rates spike. Conversely, investment-grade bonds currently sport yields of only 3.5%.

Robert Laura, a partner with Synergos Financial Group, in Howell, Mich., currently favors these funds for his yield-seeking clients. "The extra yield gives you a cushion," he says. "Most pay out monthly, and we combine them with dividend-paying securities."

High-Yield Bonds Aren't Cheap

But high-yield corporate bonds can cost you. Investors have been snapping them up for a while. Shepherd gauges value by looking at the spread between junk bonds and Treasuries, and it's narrowing. "Right now, it's about 5%," he says. "The historical average is 4.5%."

Here's how to scout out high-yield corporate funds.

Research the niche. Morningstar.com rates funds and their holdings. "Investors have to understand a manager's goal," Gogerty says. "Is it total return or yield? Also, look for lower costs, tenured management teams and a track record of success."

Stay away from funds with D-rated bonds. "They would do poorly if the economy softens," Shepherd says.

The most popular bonds offered by firms like Vanguard Group Inc. mostly hold a "B" rating, Laura says. "That's a good range for ratings," he says.

Diversify. High-yield bond funds that diversity their holdings nationally always are safer than, say, single state ones. Also, by diversifying your fixed-income investments beyond just high-yield funds and into other fund sectors like investment-grade corporate bonds, you help spread out risk, Gogerty says. "Other corporate bond funds typically don't invest in high-yield bonds," he says.

Never put more than 15% of your assets in one single fund, says Adam Bold, CEO of The Mutual Fund Store, in Overland Park, Kan.

Ask yourself: How much volatility am I willing to accept? Short-term junk bonds are more than twice as volatile as investment-grade bonds. In 2008, high-yield funds lost 26% but returned 46% in 2009. Last year, they returned 14%, according to Morningstar. Look at 52-week highs and lows to gauge fund volatility.

"Don't buy and hold bond funds," Shepherd says. "Hold them as long as the economy is doing well. If we head into another recession, it's time to shift to safer bond funds."

Go with high-yield bond mutual funds rather than exchange-traded funds, or ETFs. ETFs are twice as volatile as mutual funds, adding another layer of risk to these bonds. That's why Laura prefers investing in high-yield bond funds.

Consider the higher expense ratios. High-yield bond funds have slightly higher expense ratios than investment-grade bond funds. "An expense ratio of 80 basis points or lower is what to look for," Shepherd says. "Know what you're buying."