5 Jewels Among Junk-Bond Funds

To say that the term high-yield bond is a bit of a misnomer nowadays is an understatement. Below-investment-grade corporate bonds, more commonly known as junk bonds, are paying an average of 6.5%. That is a near-record low as measured by the BofA Merrill Lynch U.S. High Yield Master II index. Yet investors are so starved for income that this historically paltry number shines like a diamond trapped inside a lump of coal. So the questions you need to ask are whether the risks of junk bonds justify their low payouts and whether it’s time to buy or to head for the exits before the crowd gets the same idea.

Junk bonds are debt issued by companies with a credit rating of below BBB from Standard & Poor’s or Baa from Moody’s. Yields on junk bonds have often floated in double-digit territory; but a fairer way to determine value in these bonds (not to mention the degree of fear among investors) is to compare their yields to Treasury bond yields. Historically, the gap has fluctuated between six to eight percentage points, although it narrowed to 2.5 points in 1997. But in late 2008, at the height of the financial crisis, junk bonds yielded an astounding 21 points more than Treasuries. Now the spread has closed to 5.6 points. “There’s a scramble for income, and the only place to get it is high yield,” says Kathleen Gaffney, a former manager at Loomis Sayles Bond, a go-anywhere fund that is a member of the Kiplinger 25 and holds 17% of its $22 billion of assets in junk bonds. (See FUND WATCH: Should You Follow Kathleen Gaffney Out of Loomis Sayles Bond Fund?)

But sometimes it makes sense to pay up for a better product. These days, junk is less risky than it used to be. Lower interest rates allow companies to raise money on vastly more affordable terms. And more than half of the money raised in new junk-bond issues this year was used to refinance old debt at lower rates, helping companies bolster their balance sheets, says Fran Rodilosso, a manager at Market Vectors exchange-traded funds. Default rates—a big concern if you’re investing in high-yield bonds—are dropping; about 3% of issuers are defaulting per year, below the historical 4.6% average. In fact, hundreds of low-grade borrowers are on track to win a rating upgrade. When that happens, the price of a junk bond often jumps.

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Another plus for junk bonds is that their prices are less sensitive to interest-rate moves than other types of debt. When rates rise, just about all other bonds lose value. Junk stands apart because rising rates are usually tied to good economic growth, which in turn boosts junk issuers’ creditworthiness and can help the bonds gain value. At the same time, junk bonds move much more in lock step with the stock market than other types of bonds do. Junk bonds tumbled 30% during the 2007–09 stock market debacle but have since returned a sturdy 117% (all recent returns are through October 4).

What to Do Now

Many experts say that junk bonds are suitable for most portfolios. “We’ll always have some exposure to high yield because our strategy is to be balanced and diversified,” says Jeff DeMaso, head of research at Adviser Investments, a Newton, Mass., money manager. The firm has about 20% of its clients’ fixed-income portfolios invested in high-yield bonds.

But check your expectations before you jump in or add to your current holdings. So far this year, the Merrill Lynch U.S. High Yield index has already powered ahead 12.4% (the figure includes interest and price appreciation), and the average junk-bond mutual fund has gained 11.7%. Says Thomas Price, manager of two Wells Fargo junk funds: “If people think they are going to get 10% to 15%—no. But if, over the next 12 months, people expect 6.5% before fund fees, where else are you going to get a return like that?”

With that in mind, we searched for junk-bond funds that don’t stretch for extra yield by overdosing on extra-speculative IOUs. In other words, we ruled out funds that are stuffed with bonds rated triple-C or lower.

We’ll start with Wells Fargo Advantage Short-Term High-Yield Bond Investor (symbol STHBX) and Wells Fargo Advantage High Income Investor (STHYX). Both are run by Thomas Price, Kevin Maas and Michael Schueller. Short-Term High-Yield is one of the few funds that, as its name suggests, buys short-maturity junk bonds. Its average duration (a measure of interest-rate sensitivity) is just 1.6 years, which means your principal would be affected little by rising interest rates. Despite its low risk profile, Short-Term returned 4.9% annualized over the past five years, compared with 6.5% for the average junk-bond fund. But the trade-off for keeping a lid on interest-rate risk is a modest 2.4% yield. Short-Term High-Yield works well as one side of a “yield barbell”—that is, opposite a fund that takes more risks and delivers a more-generous yield of 5% or better.

That opposite number, Advantage High Income, has an average maturity of 5 years and average duration of 4 years—figures that are more typical of funds in the high-yield category. High Income is more conservative than many junk funds, so its 4.5% yield is moderate. But Price, Maas and Schueller have achieved the unusual feat of producing above-average returns with below-average risk. Over the past five years, High-Income returned 7.5% annualized, and did so with 21% less volatility than its peers.

Another source of reliable returns with little drama is Fidelity Focused High Income (FHIFX). Focused refers to a concentration on double-B bonds—nearly 70% of the fund’s assets and twice that of a typical junk fund. Bonds with double-B credit ratings can be one step away from an upgrade. Manager Matthew Conti says Fidelity created this fund to offer high income without a great amount of risk. It has delivered on both fronts: Over the past five years, Focused High Income was 16% less volatile than the typical junk fund, but its 6.9% annualized return beat the category average. The 3.9% yield suggests that Focused High Income is between the two Wells Fargo funds on the risk-reward spectrum.

To stretch for more current income, try USAA High Income (USHYX), which has a current yield of 6.5% and can venture into other high-yielding assets besides junk bonds. So while about 69% of its assets are in high-yield corporates, the rest are in foreign bonds, commercial mortgage-backed securities and preferred stock, plus some cash. That’s because the value-oriented managers, Matthew Freund and Julianne Bass, don’t take big chances even as they pursue a bonus yield. The fund returned 8.0% annualized over the past five years, handily beating the typical junk-bond fund.

Among ETFs, we like SPDR Barclays Capital High Yield Bond (JNK). It’s done a better job of tracking its bogey than its bigger rival, iShares iBoxx $ High Yield Corporate Bond (HYG). The SPDR fund’s expense ratio of 0.4% is 0.1 percentage point lower than HYG’s as well. JNK yields 5.7%; over the past three years, it earned 12.3% annualized.

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