In a low-interest-rate environment, high-yield bonds are living up to their names, generating substantial interest income, says Mark Hudoff, portfolio manager of Hotchkis & Wiley High Yield in Corona del Mar, Calif. Even after defaults, investors still earned above-market returns that beat investment grade, he said. Indeed, his fund has had a trailing 12-month yield of 5.4% over the past year, according to Morningstar.
- Read more: 10 Biggest High-Yield Bond Funds
Currently, he says, high-yield bond funds are earning roughly 4 percentage points above Treasuries, and defaults are just above 1%. While high yield defaults are on the rise--estimates call for a rate of 1.5% to 2% before the end of 2015--they are still well below the long-term average of about 4.4%. All of that makes high-yield an attractive option compared to investment-grade bonds. Even if the high-yield funds take some defaults, say for 50 basis points, they still can produce as much as three times the yield of investment-grade bonds.
Income, while attractive, isnt the only reason to consider high-yield bonds. They also have a very low correlation with Treasuries an average of 0.4. Bonds rated single-B have an even weaker link to the Treasury market. Compare that to an almost one-to-one correlation between investment grade bonds and Treasuries, Hudoff says.
That being said, says Hudoff, High-yield bonds arent 100% immune from interest-rate risk. He expects investors to pull back from the category a bit when the economy improves and the Fed starts raising interest rates.
Mark Freeman, chief investment officer and senior portfolio manager at Westwood Holdings Group in Dallas, says his firm runs a short duration high-yield strategy, which has significantly lower interest-rate risk due to its short duration. In this yield environment, we think this is the smartest way to participate in the high yield space, as it manages downside interest rate risk while maintaining an attractive yield profile, he says. The fund has posted gains so far this year of 1.06% and a loss of 1.11% last year, according to the company's numbers. The fund saw gains in the previous two years of 5.15% and 6.08%, respectively.
CHOOSING FUNDS, NOT BONDS
Harriet J. Brackey, advisor at Hollywood, Fla.-based KR Financial Services, says she declines to recommend individual high-yield bonds, and only uses funds. Im an advisor, not a credit analyst, Brackey says. I count on fund managers who have boots on the ground and who are doing detailed analysis of these bonds day-in and day-out.
Multi-sector bond funds are one way to get a measured exposure to high-yield bonds, and are a vehicle favored by Gary Sidder, president of Life Transition Planners Inc. in Littleton, Col. The funds he chooses generally have a 15-35% exposure to high-yield bonds. A dedicated high-yield bond fund, he says, would tend to move much more similarly to a stock fund. The benefits of multi-sector funds are many, he says. This gives us some exposure to high-yield bonds, limits the volatility in owning dedicated high-yield bond funds, and further diversifies our bond holdings.
Katie Kuehner-Hebert is a freelance writer in Running Springs, Calif. She has contributed to American Banker, Risk & Insurance and Human Resource Executive.