The Limited Role of High-Yield Junk Bonds

(MoneyWatch)  With yields on bonds so low, people are searching for anything that pays a higher yield. That's why I'm often asked by clients what I think about high yield bonds (aka junk bonds) as part of their fixed-income portfolio. My answer might seem contradictory in that I will reveal that I do own some high yield bond funds, but will also urge them not to consider them part of my fixed income portfolio.

High yield bonds are called junk bonds because they have high default risk. The corporations issuing these bonds may go belly up, possibly making the bonds worthless. Standard and Poor's, Fitch and Moody's, rate "junk bonds" BB or lower. Yields are very attractive, however, with the Vanguard High-Yield Corporate Bond Fund (VWEHX) yielding 7.41 percent annually.

I bought this bond fund in the fall of 2007, during the height of the liquidity crisis where only U.S. Treasuries held up. But I bought this as part of my rebalancing strategy, and consider it part of my equities. So far this year, the fund is up about 34 percent, far more than the U.S. stock market. The soaring price has brought the yields down far below the double digit yields of late 2007.

I'm not arguing that high-yield bonds are stocks. They are clearly fixed income and Morningstar classifies them as such. But the risk characteristics are much more closely associated with equities. Looking over the past couple of years, the U.S. stock market and high yield bonds have tracked each other very well.

Buying high yield bonds
If you are considering buying these junk bonds, my advice is as follows:

1. Don't buy them because you want a higher yield. Bonds should be part of your portfolio's shock absorber. Keep your bonds mainly in U.S. backed securities. Consider junk bonds as part of your equity portfolio.

2. Don't expect another 34 percent return next year. Bond rates plunged causing the returns to soar. That can't happen again unless rates fall to near zero.

3. Always buy your junk in funds. Like stocks, individual bonds carry uncompensated risk. Unlike stocks, they can cost several hundred basis points (several percent) to sell.

4. Remember that these are risky. If ten percent of the bonds in the portfolio fail in any given year, with no recovery of assets, a 7.4 percent yielding fund turns in a minus 2.6 percent annual return.

There is nothing wrong with a little junk in your portfolio. But don't think of this as a safe asset like you should be doing with your core bonds.

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