In the years since the global credit crisis and subsequent recession, near-zero interest rates have presented a challenge, to say the least, for investors searching for yield. But in today’s environment, holding high-yield bond funds may not be worth the credit risk that comes along with them.
Investors who haven’t held high yield bond funds for at least the past eight years may not be aware of this risk, which is extreme compared to the total bond market.
For example, in late 2007 the credit crisis reared its ugly head and investors began running for the exits by selling stocks and bond funds that were holding bonds with low credit quality — the high-yield bonds, which have another name — junk bonds.
In 2008, the average high-yield bond fund got slammed with a 26% price decline compared to a 5% gain for the Barclays Aggregate Bond Index.
So high-yield investors are now faced with a decision: Can your portfolio (and risk tolerance) remain in tact during an account value decline of 20 to 30% for a period of a year to 18 months? A decline in price means a decline in income.
Here are 3 bond funds that have above-average yields with much lower credit risk and price risk than high-yield bond funds.
Vanguard Long-Term Investment Grade Bond (VWESX)
30-Day SEC Yield: 3.96%
Likely the only bond fund you’ll find with a combination of a yield above 3%, above-investment-grade credit rating, low expenses, and accessibility to everyday investors is Vanguard Long-Term Investment Grade Bond (MUTF:VWESX).
In general, if your bond fund has a yield higher than 4%, you can expect a decline in market value in the next correction. This is because the most common way to get those high yields in the current environment is with bonds that are below investment grade (junk).
The average credit quality for the bonds held in VWESX is slightly above investment grade, which is measured by a “BBB” rating by Standard & Poor’s.
It is important to note, however, that VWESX and other long-term bond funds are higher in interest rate sensitivity, which means that low or even negative returns are possible in the short-term. However, in a flight to quality, you’re not likely to see the big declines that are common with high-yield bond funds in a major correction.
The expense ratio of VWESX is a low 0.22% — or $22 annually per $10,000 invested — and the minimum initial investment is $3,000.
T. Rowe Price Corporate Income (PRPIX)
30-Day SEC Yield: 3.02%
If you are looking for a bond fund with an outstanding balance of risk, return and yield, T. Rowe Price Corporate Income (MUTF:PRPIX) is well worth a look.
The average credit rating is BBB, which is right on investment grade, and the average effective duration and maturity for PRPIX is intermediate-term. This means relatively low credit risk compared to high-yield bond funds and lower interest rate risk compared to long-term bond funds.
PRPIX also comes with a seasoned manager, David A. Tiberi, who has been with the fund since 2003. During the credit crisis of 2008, Tiberi was able to manage a 3.7% gain, compared to the steep decline of -26% for the average high-yield bond fund. Long-term returns also look solid with the 5-year, 10-year and 15-year performance ranks comfortably better than the average corporate bond fund.
The expense ratio for PRPIX is average at 0.63% and the minimum initial investment is $2,500.
iShares iBoxx $ Investment Grade Corporate Bond (LQD)
30-Day SEC Yield: 3.16%
There are a small handful of ETFs that provide decent yields without the credit risk of high-yield bonds and iShares iBoxx $ Investment Grade Corporate Bond (NYSEARCA:LQD) is one of them.
The bond ETF offers diversified exposure to more than 1,000 high-quality corporate bonds, which yield much higher than government bonds without the concern over big price declines typical of high-yield bond funds.
Also worth mentioning is the fund’s liquidity, which is important to smart ETF investors. With $22.5 billion in assets, LQD is among the largest and most liquid among the corporate bond ETF universe of funds.
As for price stability, LQD has only had one year of negative returns, which was -2% during the recent small correction in 2013.
The rock-bottom expense ratio of 0.15% is also difficult to beat.
As of this writing, Kent Thune did not personally hold a position in any of the aforementioned securities. His No. 1 holding is his privately held investment advisory firm. Under no circumstances does this information represent a recommendation to buy or sell securities.