High yield bond funds are easy to understand if you can grasp the basic contradiction at their heart. Investors think of bonds and bond funds as the safe part of their portfolios. Bond pricing stays steady and bonds generate regular revenue from interest payments. A bond fund is often the most boring part of a diversified investor’s portfolio. All these characteristics of bonds are the exact opposite of stocks and stock funds (wildly fluctuating prices, very little revenue generated from dividends) which tend to be much more volatile and exciting.
High yield bond funds have characteristics similar to both traditional low-yield bond funds and stocks. This article explains what high yield bond funds are and how they differ from high-quality bond funds and stock funds.
What is a High Yield Bond?
A high yield bond (called a junk bond by some analysts) is a bond that is rated lower than investment-grade. The three major credit rating agencies, Moody’s, S&P and Fitch, maintain a set of grades that are assigned to debt issues. These grades range from AAA/Aaa for United States Treasury bonds all the way down to C/CCC- signifying issuers who have already defaulted on their interest payments.
Bonds with grades in the top tier (above Baa3 or BBB-) are considered investment-grade. This means that the issuer is healthy and there is an extremely low likelihood of default. (See a complete list of bond credit ratings.)
Bonds with grades in the lower two tiers are considered high yield. This distinction is extremely important because investors who purchase high yield bonds demand a risk premium. Therefore, the interest rates on high yield bonds are significantly higher than on investment grade bonds. Investors should remember the words of investment guru William Bernstein, author of The Four Pillars of Investing: “Risk and reward are inextricably intertwined.” High yield bonds offer greater returns because there is a significant likelihood of default on the part of their issuers, potentially leaving investors holding nothing but an empty promise.
There is a reason that those who do not favor high yield bonds call them junk bonds.
How High Yield Bond Funds Work
High yield bond funds are essentially pools of bonds rated below investment grade. Most investors purchase high yield bond funds because the interest payments received are significantly higher than those that can be found on safer debt instruments like Treasury bonds or investment grade corporate bonds. For example, at the time of this writing, the Vanguard High-Yield Corporate Fund (VWEHX) had a yield of 7.22%. This compares extremely favorably with the seven-year Treasury rate of 3.08% and the Vanguard Intermediate-Term Investment Grade bond fund (VFICX) which yielded 4.11%.
Investors considering purchasing a high yield bond fund should consider the same criteria as investors in any mutual fund: expenses, management type and risk of principal loss.
The Risks of High Yield Bond Funds
Alas, the high payout associated with high yield bond funds is not without risk. The primary risk of investing in high yield bond funds is the risk of principal loss.
Consider this example: investors who purchased shares of the Vanguard high yield corporate bond fund (VWEHX) in September of 2008 saw their principal lose 25% of its value in just a few weeks. The worst three-month return on record for this fund is -25.52%. Compare this to the Vanguard intermediate term investment grade bond fund (VFICX) referenced above, the worst quarter of which resulted in a loss of -11.71%.
Now, an 11.71% loss is severe, especially in the safer part of an investor’s portfolio. A loss of 25% is enough to send many investors running for the hills.
Based on this measure of volatility, an investment grade bond fund is twice as stable as a high yield bond fund. Investors who put their capital to work in a high yield bond fund will experience a great deal of volatility.
Because of their volatility, many investment advisors do not recommend high yield bond funds. Their logic goes like this: these bond funds are about as volatile as stocks. However, bond funds have a limited upside whereas stocks have an unlimited upside. Therefore, their reasoning goes, why not invest in stocks instead?
Despite their shortcomings, there is a place for high yield bond funds in some investors’ portfolios.
The Role of High Yield Bond Funds in a Diversified Portfolio
The benefit of high yield bond funds is their yield. High yield bond funds generate a significant amount of revenue and therefore may help investors who seek to generate significant cash flow – but only if they can ignore the value of fluctuating principal.
Because of their volatility, it is recommended that a diversified investor think of high yield bond funds as a part of the stock allocation of their portfolio. For example, if an investor with a standard balanced portfolio of 40% fixed income and 60% stocks (as recommended by Bill Schultheis, author of The New Coffeehouse Investor) wished to enhance their fixed income with a high yield bond fund, the amount invested should count toward the 60% stock allocation. This is because the risk profile of high yield bond funds are much more similar to stocks than investment grade bonds.
Investment advisors Merriman, Inc. recommend high yield bond funds to help diversify a 100% fixed income portfolio. In the case of a portfolio that is completely fixed income, the volatility of a high yield bond fund helps to reduce risk through diversification.
Diversified investors select bonds and bond funds that have a low correlation to the overall stock market. Because high yield bond funds are more volatile and more correlated to stock market movements, they should be considered a stock investment in many cases.
Despite their risks, the high returns of high yield bond funds earn this asset class a place in many investors’ portfolios. So long as an investor understands the risks associated with high yield bond funds and their overall role in a diversified portfolio, and has a strong stomach for drastic fluctuations in value, she should not be afraid to add exposure to this asset class. However, all investors must remember that diversification is key to investing success. Excessive exposure to a single asset class is likely to result in loss of principal as well as ulcers and sleepless nights.