Loading up on junk bonds
High-yield bond funds have the potential to generate impressive returns, but those yields don't come risk free.
NEW YORK (Money) -- Question: I'm 63 and planning to retire in three years. I'm considering investing in high-yield bond funds because they generate good income. Do you think I should do this and, if so, what percentage of my portfolio allocation should I devote to high-yield funds? --Frank, Groveport, Ohio
Answer: True to their name, high-yield corporate bond funds can offer some pretty lofty payouts. The Merrill Lynch High-Yield 100, a widely followed index of the 100 largest high-yield bond issues, recently yielded just over 8%, about three and a half percentage points more than investment-grade intermediate-term corporate bonds and four and a half percentage points more than 10-year Treasuries. And you can find many high-yield bonds yielding much, much more.
But those higher yields don't come risk free. As you no doubt know, high-yield bond funds are also known as junk bond funds. That's because, true to their name, these funds invest in bonds rated below investment grade, or junk in Wall Street parlance.
The fact that the debt didn't qualify for an investment-grade rating means that the company that issued the bond has a higher chance of defaulting on its obligation to make timely payments of interest and principal. And even if the bond issuer doesn't actually default -- and they usually don't -- the fact that the odds that a default could occur are higher affects the price that investors are willing to pay for junk bonds.
So when you're considering a high-yield bond fund you can't just look at the yield. You've also got to consider what might happen to the underlying price of the bonds (and, hence, the price of the bond fund), since it's the combination of income and price changes that determine the true return on your investment.
The appropriate gauge that combines both the income generated by bonds as well as any changes in the market value of the bonds is the total return. That's the figure that tells you what is happening to the value of your investment when all is said and done. And if you look at the total return of high-yield bond funds recently, you'll see that they can offer quite a ride.
Last year, for example, high-yield bond funds got clobbered, with the high-yield category as a group losing 26.4% for the year. That was largely because the combination of a recession and the financial crisis shook investors' faith in the ability of companies overall, and especially those that issued junk debt, to repay their debt. Basically, investors fled to the perceived safety of Treasury bonds.
This year, however, the fortunes of junk bonds improved dramatically. As investors have become more convinced that maybe the economy isn't in a death spiral, they decided that junk bonds were a better bet than they seemed last year. So they began bidding up their prices, making high-yield bond funds the top-performer in the bond category for the year to date with an average return of 35.8%.
These sorts of swings mean that the return you get from high-yield bond funds can vary quite a bit, even over longer periods. If you check out Morningstar's fund category averages, for example, you'll see that over the past five years junk bond funds have gained an annualized 3.8% or so, only a tad more than intermediate-term bonds, which are less risky.
But there have been five-year periods in the past --notably the five years through the end of 2005, 2006 and 2007 -- when junk bond funds beat intermediate-term bonds by substantial margins. You'll find similar variations in 10-year performance, with junk bonds generally outperforming during periods when the economy is doing well.
All of which is to say that while high-yield funds do offer a shot at higher longer-term returns, those heftier gains are hardly guaranteed. And you may have to go through some periods of subpar performance, not to mention outright routs, enroute to them.
To me, this suggests that while high-yield funds may be able to play a part in the portfolios of retirees who understand what they're getting into with such funds, it should be a minor supporting role rather than starring one. I think most people nearing or in retirement are probably looking to their bond holdings for security and stability, not excitement.
How you translate a minor supporting role into a percentage is clearly a subjective matter. But I'd say 10% of one's bond holdings is a reasonable starting point from which you can either move up or down, depending on what sort of fluctuations you're willing to accept in the value of your bond holdings.
That said, I don't think a retiree -- or any other investor, for that matter -- would be doing themselves a big disservice by sticking to a broadly diversified portfolio of investment-grade bonds, which you can do by simply buying a total bond market index fund, such as the one that appears on our Money 70 list of recommended funds.
If you do decide to throw a high-yield fund into your mix, you might want to consider going with a fund that invests in what one might oxymoronically call higher-quality junk, or bonds rated B or higher. While such funds can still get hammered, they're likely to hold up better during cataclysms than funds that focus on the bottom of the junk pile. You can check out the quality of a high-yield fund's portfolio by plugging its name or ticker symbol into Morningstar's quote box.
So if you want to invest a modest portion of your savings in high-yield bond funds, go ahead -- but do so only if you're also willing to accept the higher risks that go hand in hand with their attractive yields and potentially higher returns.