NEW YORK (MONEY Magazine) - Junk and foreign bonds beat going long. Risk: High-yield debt is more tied to economic ups and downs.
With interest rates still low, it's tough to get a big payout from your bond investments nowadays. What to do?
You might be tempted to try and squeeze out extra yield by getting into longer-maturity bonds, but you won't be well rewarded for taking on the extra interest-rate risk. (Rising rates mean falling bond prices, and longer bonds generally fall furthest.) The yield on 10-year Treasury bonds was a slim 4.2 percent in November, not an awful lot more than the 3.5 percent you could get on a safer five-year bond.
So instead of going long to get more yield, go low -- in credit quality, that is. High-yield or "junk" bonds are offering up to 3.5 percentage points more than Treasuries of similar maturity.
This is a supplement to your core bond holdings, not a replacement for them. After all, you're adding some risk here: Junk bonds (defined as those rated below BBB) pay investors more because there's a higher chance the businesses behind them will fail to make their payments.
But with a strong economy, default rates are running at just 2 percent, compared with the historical average of 4.75 percent.
Two caveats: First, prices of junk bonds have had a strong run in recent years, so you shouldn't expect huge returns beyond the yield. And you should favor the higher-credit issues in the junk spectrum, because you won't get much extra yield by taking a chance on shakier bonds.
You can best mitigate credit risks by buying junk through a mutual fund -- over time, junk funds tend to be more volatile than conventional bond funds but steadier than stock portfolios.
Pioneer High Yield fund is at the head of its class. It yields 5.6 percent and has logged annualized returns of 13.78 percent over the past five years. Manager Margaret Patel says that she's recently been shifting the portfolio towards higher-quality junk.
If you want even more yield than junk can offer -- and are even more adventurous -- consider an emerging-markets bond fund. The economic health of many developing nations is steadily improving, so that they have less debt as a percentage of their gross domestic product.
Almost 50 percent of emerging-market debt is rated as investment grade (including that of Hungary, Malaysia and El Salvador), yet in aggregate the sector yields over 8 percent. And as these countries have become less reliant upon external borrowing, they are issuing fewer bonds. Scarcer bonds and improved creditworthiness should add up to higher prices.
The best play here is Payden Emerging Markets Bond fund, which limits its risk by holding no more than 20 percent of assets in any one country and favors the sector's highest-quality issuers. It yields 6 percent.
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