Scenario 3: You just want a decent income

Paul J. Lim, assistant managing editor


What you've been doing: Buying high-yield corporates and municipal bonds.

Stretching for yield always carries risk. After all, when bond issuers pay greater-than-average yields, they're doing so not out of generosity but because they have to pay more to attract investors. Still, after the indiscriminate beating that high-yield corporate (a.k.a. junk) bonds took in the panic of 2008 when they were yielding 24% or more, or eight times what Treasuries were paying -- MONEY saw real value there.

High-yield bond funds went on to return an annualized 33%. Thanks to those eye-popping gains, high-yield funds pulled in 50 times more money in 2009 and 2010 than in the rest of the decade combined.

They don't look as great today. The average junk bond now yields around 8%, and the spread between these yields and Treasuries is about 20% below where it was pre-panic. If the yields on new junk go back to where they used to be, the value of the bonds you already own could sink.

Municipal bonds look iffy too. The feds don't tax income from munis, which are issued by cities, counties, and states to finance roads, bridges, and other public works. So if you're in the 28% bracket, the current 3% yield on a 10-year AAA-rated muni is really like 4.2% -- a number that has sent investors flooding in.

However, the average intermediate-term muni bond fund has lost around 3% of its value since the start of September as interest rates have risen. Moreover, many cash-strapped locales could have trouble making payments, raising the risk of default.

It is likely to take years for them to work through their budget problems, prompting them to issue more debt down the road -- and that increase in supply could lower the price of the bonds you already hold.

Smarter strategy: Lower your credit risk -- and practice patience

Make a total bond market fund your core holding, then add some corporate bonds to juice your yield a bit. But steer clear of the lowest-rated junk. Thomas Carney, a portfolio manager with the Weitz Funds, suggests high-quality junk bonds (that is, those rated from around B to BB) or low-quality investment-grade corporates (BBB). "That's where the values are," he says.

A solid fund that owns both: Columbia Corporate Income A Load Waived (LIIAX.LW) (yield: 5.8%). About 20% of its portfolio is in junk, the rest in investment-grade debt.

Another way to get high-quality junk is through floating-rate bank loan funds. They buy extremely short-term adjustable-rate commercial loans that reset every one to six months and therefore benefit when rates rise.

These loans are made mostly to non-investment-grade companies. But they're higher in quality than your average junk because bank loan holders receive preferential treatment to bondholders in the event of bankruptcy.

Still, for extra safety, go with a fund that holds mostly loans rated BB or higher, such as Pioneer Floating Rate A Load Waived (FLARX.LW) (yield: 4.6%).

In a rising-rate environment, "holding on is the key," says David MacEwen, chief investment officer for fixed income at American Century Investments. Say you own a short-term bond fund with a duration of two years. If rates rise by one point, the fund will fall 2% in value.

But over the course of the year, the fund will see its bonds come due and reinvest that money into higher-yielding debt. So if that fund's yield climbs from 1% to 2% in that time, you could break even.

"If you're investing with the idea that once rates go up you'll sell," he says, "you're going to lose money." And that's anathema to any bond investor. To top of page

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