Junk Bond Funds to Protect Against Rising Rates

Low yields combined with talk of the Federal Reserve scaling back its easy-money policies have left bond investors with a big headache. (Editor's Note: After this column was first published in the February 2014 issue of Kiplinger's Personal Finance magazine, the Fed announced its plans to begin tapering its bond-buying program in January 2014. For more information, see Interest Rates and the Fed's Taper.) So it’s no surprise that more investment firms are rolling out short-term high-yield bond funds to try to ease the pain. At least four companies, including Fidelity, did so in 2013.

Like other junk bond funds, the new products invest in debt issued by lower-quality companies. The relatively high interest payments from the bonds provide some cushion against rising interest rates (bond prices and rates generally move in op­posite directions). In addition, the new funds’ short maturities (about three-and-a-half years, on average) should further insulate their share prices from rising rates. “When you shorten the investing time frame, you can have much more confidence in a company’s credit story,” says Matt Conti, lead manager of Fidelity Short Duration High Income (symbol FSAHX), which launched in November 2013.

The big catch is that most short-term junk funds don’t have much of a record. Moreover, the flurry of new funds is coming at a time when junk’s yield advantage has shrunk. At the end of 2013, the gap between short-term junk bonds and comparable Treasuries was a bit more than 4 percentage points. A year earlier, the spread was 6.6 points. If the economy stumbles and investors get nervous about the ability of companies to repay their debts, junk bond prices could fall, says Chris Cordaro, chief investment officer at RegentAtlantic Capital.

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So stick with funds that favor bonds rated double-B (the highest quality of junk) and single-B. Wells Fargo Advantage Short-Term High Yield Bond (STHBX), which has a 16-plus-year record, is a good bet. The fund yields 2.1%, and over the past year through November 29 it produced a total return of 3.7%. That’s nothing to gloat about. But when the junk bond market swoons, the fund tends to beat its peers. In 2008, for example, Advantage lost 5.8%, compared with a plunge of 26.4% for the average junk bond fund.

Fidelity does a good job with bonds, so its new fund bears watching. The fund aims to keep about 10% of its assets in high-grade bonds, providing a bit more protection against market shocks (its yield was not available at press time). Prefer a longer track record? Consider Fidelity Floating Rate High Income (FFRHX), which buys bank loans made to low-quality firms. Interest rates on those loans reset every 30 to 90 days, so the fund is well protected from rising interest rates. The fund yields 2.5% (for more, see Get 3% with Low Risk Via Floating-Rate Bond Funds).