Sweet Smelling Junk: High-Yield Funds Have Had a Strong Showing

US News

Investors in bond mutual funds have not gotten much good news in recent months. Indeed, bruising outflows and negative returns are becoming the new normal as investors, worried about rising interest rates, increasingly turn their attention to the stock market.

But even as the broader bond market has tanked, high-yield funds have demonstrated some resilience. According to Morningstar, high-yield funds are one of just three types of bond funds (the other two categories are ultra-short bond funds and funds that invest in bank loans) still in the black so far in 2013.

[Read: Target-Date Funds Sliced By Bond Buzzsaw.]

High-yield funds invest in "junk" bonds, which are fixed-income securities with credit ratings of BB or lower. Relatively speaking, these funds are high-risk, high-reward products. The risk of default is higher than it is with most other bond funds, but so are the yields.

So far this year, investors willing to go digging around in the trash have been rewarded. Through Monday, funds that focus on junk bonds were up by an average of 2.6 percent in 2013, according to Morningstar. By comparison, funds that specialize in long-term U.S. government debt fell by an average of 13.5 percent.

Junk bonds have been outpaced by their fixed-income competitors for two reasons: a measured sense of optimism among investors about the strength of the economy and a desire for higher yields.

In other words, with 10-year Treasury bonds yielding just 2.88 percent, investors have been willing to take on the risk that comes with high-yield bonds in exchange for higher yields. Their willingness to do so has been compounded by optimism about the country's economic heath because a more robust economy tends to lessen the risk of default.

"A stable and growing economy is a good environment for high-yield bonds. And where the Federal Reserve is staying in the market and keeping [interest rates] low, investors have had to stretch to get income and to get yield," says Jeff Tjornehoj, Lipper's head of Americas research.

[See: 12 Surprising Facts About Boomer Retirement.]

But just as these two factors have kept high-yield funds on top of the fixed-income market this year, a reversal in either could put a damper on positive returns. Of particular concern to all fixed-income investors, including those with exposure to high-yield bonds, is the prospect that the Fed will finally begin its so-called "tapering," gradually ending its large-scale bond-buying program has kept interest rates low. Speculation is mounting that the government will cut back on the initiative as early as next month and allow rates to rise.

All bond funds would be affected because bond prices go down when interest rates go up. Junk bonds, however, could also be hurt in a second way: In a rising-rate environment, investors will be able to get decent yields in investment-grade options and may be less likely to want to take on the risks that junk bonds entail.

Although higher rates are inevitable, analysts are divided about when to expect them. "So much is going to be determined in September when we get more [info] on tapering," notes Fran Rodilosso, a fixed-income manager for Van Eck Global.

Even so, Sarah Bush, a senior analyst for Morningstar, cautions that higher interest rates won't necessarily be disastrous for junk bonds. That's because although a portion of their yield strongly depends on interest rates, another portion does not. That second portion is called the spread, and it refers to the premium investors get in exchange for taking on added risk.

[See: 7 Mutual Funds for Gamblers.]

Bush notes that a more dire situation for high-yield investors would be a prolonged slump in the stock market. That's the case because junk bonds are "much more sensitive to what's going on in the equity market than what you're going to see in a high-quality bond," she says.



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