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Tempted by High(er) Yields on Junk Bonds? Read This First

We share some picks--and review the risks--in this volatile market segment.

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"High-Yield Bonds Poised to Outperform in 2015." 

"Western Asset: Tremendous Opportunities in High Yield." 

"O'Reilly: High-Yield Bonds Should Weather the Oil Shock." 

These were recently among the top headlines on's Bond tab. The reason for the enthusiasm, in large part, is that high-yield bonds have decent yields again, though it may be a stretch to call them "high." Most high-yield bond funds have yields in the neighborhood of 6% today, nearly two percentage points higher than in mid-2014. Those higher payouts provide investors with a better cushion against principal losses than they had even a few months ago. And while sinking energy prices have weighed on the high-yield debt market, causing yields on energy bonds to spike, some market watchers think that high-yield bond defaults should remain benign. 

Thus, it's not an unreasonable time to give high-yield bonds another look. Below, I've highlighted some ideas--both direct and indirect--for delving into the sector. But before venturing into this market segment, it's also a good time to review its risks. At a minimum, high-yield exposure may be redundant for some investors, giving their portfolios greater equity sensitivity than they may have intended them to have. 

Bulls and Bears 
First, the bull case: The yield differential between Treasury bonds and high-yield, or junk, bonds had been generally shrinking since late 2008 (albeit with a few spikes along the way); but it recently widened out a bit, owing in part to declining oil prices. Whereas the differential--or spread--dropped below 3.5 percentage points back in mid-2014, it was nearly two percentage points higher as of early February. That's because much of the issuance in the high-yield bond sector comes from energy firms, many of which took on debt to finance projects when oil prices were rising. But as oil prices have declined recently, high-yield energy bond prices have dropped sharply, boosting their yields. 

Some bond investors think that investors have overreacted. Morningstar's corporate bond strategist Dave Sekera notes in this article that he expects high-yield bonds to outperform other corporate bonds in 2015. While he acknowledges that defaults in the energy sector could tick up, he believes the overall default rate for high-yield bonds will stay in the low single digits. 

The team at  Western Asset Core Bond (WATFX), which took home Morningstar's Fixed-Income Fund Manager of the Year honors for 2014, also believes that high-yield bonds are a buy right now and that investors who are selective within the beaten-down high-yield energy arena will be rewarded

The Western Asset team isn't alone. In this video, manager research analyst Sumit Desai took note of several top high-yield fund managers who are bullish on energy right now, including the teams at  Franklin High Income (FHAIX),  Neuberger Berman High Income Bond (NHINX), and  Janus High-Yield (JAHYX)

That said, not every high-yield specialist is betting on energy bonds. Desai notes that some high-profile high-yield managers, including the teams at Gold-rated  Fidelity High Income (SPHIX) and Bronze-rated  PIMCO High Yield (PHDAX) have historically downplayed energy. 

First, a Redundancy Check
Even investors who are inclined to dabble in the unloved high-yield sector should assess whether adding a dedicated high-yield offering makes sense at all. 

For one thing, many investors may already have some junk exposure in their portfolios, as most broadly diversified bond funds have some latitude to venture into bonds rated below investment-grade. The typical intermediate-term bond fund has about 7% of assets in bonds rated BB or below currently, and some intermediate-term funds carry substantially higher weightings than that. For example, Gold-rated  Loomis Sayles Core Plus Bond (NEFRX) can hold up to 20% of its assets in bonds rated below investment-grade. 

Funds that land in the non-traditional- and multisector-bond categories usually have even higher allocations to high-yield bonds. For example, the typical non-traditional-bond fund has about 17% in bonds rated BB or below and another 3% in nonrated bonds. Multisector-bond funds have 24% of their portfolios, on average, in bonds rated BB and below, and an additional 5% in nonrateds. 

Many funds in Morningstar's various allocation categories--conservative, moderate, and aggressive allocation--have also been beefing up their high-yield stakes in recent years, as outlined in this article, an outgrowth of ultralow yields among high-quality bonds. 

More broadly, whether high-yield bonds merit a slot in investors' portfolios at all is open for debate. Because their prices are sensitive to the health of the U.S. economy, junk bonds have historically had a much higher correlation with the equity market than high-quality bonds, as discussed in this article. That means that high-yield bonds won't lower an equity portfolio's volatility level in the way that high-quality bonds will. From a practical standpoint, it's likely that junk bonds would perform poorly in an equity-market sell-off--something worth pondering given that stock-market valuations aren't exactly cheap right now. In a research paper published in 2013, Vanguard demonstrated that, owing to their additional costs and idiosyncratic risk factors, the addition of high-yield bonds did not improve the risk/reward profile of a plain-vanilla stock/bond portfolio. 

Pure and Indirect Plays
That said, investors who are attracted to the high-yield sector are better off adding their exposures when the sector is beaten down and yields are higher, because they will stand a better chance of getting compensated for the risks they're taking on. For investors inclined to add to the sector, the recent sell-off in energy bonds may provide a reasonable entry point. 

Because high-yield bonds have what Morningstar senior manager research analyst Sarah Bush calls an "asymmetric risk profile--you can only get paid back at par but you can lose your full investment," individual investors can help mitigate the downside by investing in a fund rather than buying individual bonds.

Investors looking to high yield are also better off going with an active strategy versus a passively managed product. True, passive products can help reduce costs, but ETF strategist Sam Lee notes that the liquidity screens that accompany junk-bond indexes can lower returns. By contrast, skilled active managers can exploit the inefficiencies that crop up in less-liquid asset classes like high yield. 

For investors seeking a pure play on the high-yield sector, 16 funds, listed here, currently earn Morningstar Medalist ratings. The sole Gold-rated offering of the bunch, Fidelity High Income, is not among the funds currently bullish on the energy sector, but it boasts a highly seasoned manager and a disciplined process. Among the medalist funds that are emphasizing energy bonds are the aforementioned Neuberger Berman High Income Bond and Franklin High Income (both Silver-rated) and the Bronze-rated Janus High-Yield. 

Alternatively, investors could aim for a more diversified bond fund that makes room for high-yield bonds but also has the ability to de-emphasize them when the risk/reward profile isn't attractive and/or opportunities beckon elsewhere. Fourteen distinct funds rate as medalists within Morningstar's flexible-bond categories, which encompass multisector- and non-traditional-bond funds. The sole Gold-rated fund of the bunch is  Loomis Sayles Bond LSBDX, which had 26% of its portfolio in high-yield bonds as of the end of December 2014. It boasts a highly experienced management team, deep analytical resources, and a good degree of flexibility. But its latitude to invest in non-junk sectors doesn't make it tame; its 2008 losses were far worse than most multisector funds'.

No matter which vehicle investors choose for high-yield exposure, it's crucial that they have a long holding period in mind, similar to what they might use for equity exposure, because of the volatility inherent in high-yield bonds. Morningstar's Bush says, "To use high yield well, investors need to hold through periods of volatility, or even buy into them, which could be the argument for certain parts of the market today. There isn't good evidence from fund flows that they've used these funds particularly well in the past."

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Christine Benz does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.