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I've heard a lot about how rising interest rates have affected bond prices generally, but how will they affect high-yield bonds? I am thinking about adding a high-yield bond fund to my portfolio but am wondering whether I should wait until interest rates rise some more. What do you think?
-- Mark Ozerkis, New York, NY
Before I tell you what I think about your plans, I want to do a quick primer on bond risk for readers out there who aren't bond cognoscenti.
There are two types of risk in bonds. The first is default risk, or what I like to call deadbeat risk. There, the danger is that the bond issuer can't make the interest payments on the bond or repay the principal -- i.e., defaults on the bond. That doesn't usually mean the bond is totally worthless because bond holders may have claim on corporate assets. But the market value of the bond can take a big, big hit.
The second risk is interest rate risk. Think of a see-saw with interest rates on one side and bond prices on the other. When interest rates go up, bond prices go down. When rates fall, bond prices rises. The longer the bond's maturity -- the farther out it sits on the see-saw -- the more its price increases or decreases with fluctuating rates. (For more on the relationship between interest rates and bond prices, click here.)
See-saw dynamics
We had a compelling example of this see-saw dynamic earlier this year when bond rates reversed their downward slide and began to rise; 10-year Treasury-bond yields climbed from a low of roughly 3.2 percent in mid-June to about 4.2 percent recently. As a result, bonds and bond funds took a hit.
For the three months through mid-September, for example, short-term government bond funds lost 0.7 percent of their value, while intermediate- and long-term government funds lost 1.7 percent and 7.6 percent respectively, which is about what you'd expect on the basis of the see-saw theory.
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Over that same period, however, high-yield, or, to drop the euphemism, junk funds fared much better, earning 1.7 percent on average. And if you look at returns for the year to date, junk looks even better, earning 17 percent vs. about 1 percent for short- and intermediate-term government funds and just 0.2 percent for long-term governments.
So how did junk bonds manage to do so well in a period of rising rates? Two reasons. First, as their name implies, high-yield bonds pay higher rates of interest than other bonds. They're more likely to default, so they have to compensate investors by offering a higher coupon rate.
And for reasons too technical and boring to go into here, the higher a bond's coupon rate, the less it is hurt by rising interest rates. So, in general, high-yield bonds weather spells of rising rates better than most other bonds.
The second reason is that the price of high-yield bonds also tends to track investors' expectations for the economy. If the economic outlook is grim, high-yield prices tend to falter because investors expect that the companies that issue high-yield bonds -- often companies with high levels of debt and tenuous prospects -- could have trouble meeting their obligations.
When the economic outlook is brighter, junk bond prices tend to do well because junk issuers have a better shot at prosperity. So while the economy hasn't been going gangbusters lately, the consensus is definitely more toward rebound than relapse. Hence the good showing of high-yield bonds and bond funds.
So -- add high-yield bonds?
So, back to your question. I see no problem with broadening the bond portion of your portfolio to include a high-yield bond fund, although I think it would be unrealistic to expect these funds to reprise their phenomenal gains of the past year or so. (You can even launch your search at our Fund Screener.)
I also wouldn't try to time my entry into a high-yield fund on the basis of interest rates or expectations for the economy. Such timing is difficult to pull off, witness the long history of bond investors missing turns in the direction of rates.
Rather, I'd simply view high-yield bonds as a means to diversify your bond holdings in a way that helps you generate a higher interest income for your portfolio without increasing the interest rate-risk you already face with the other bond funds you own.
Finally, don't go overboard with your high-yield stake. Although high-yield bonds aren't as sensitive to rate fluctuations as conventional bonds, they're still plenty risky. I'd probably limit them to 10 to 20 percent of my bond stake.
You can adjust those percentages up or down a bit according to your own tolerance for risk. But, overall, I think junk bonds should play a relatively minor role in the bond portion of most investors' portfolios, not a starring one.
Walter Updegrave is a senior editor at MONEY Magazine and is the author of "Investing for the Financially Challenged." He also answers viewers' questions on CNNfn's Money & Markets at 4:40 PM on Monday afternoons.
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