Owning high-yield bonds can be a great way to spice up your portfolio. But even with high-yield bonds being “only the spice,” the risk could be significant.
Investors in high-yield bonds from the energy sector recently learned that lesson, surely much to their own chagrin.
When your bond is defaulted on, it does not matter how much interest you are getting. Moreover, market volatility can hit high-yield bonds significantly.
Therefore, if you really want to enjoy the extra yield but reduce the risk, you must own high-yield bonds through carefully selected exchange-traded funds or mutual funds.
In this case, “carefully selected” means the kind of funds that have a strong emphasis on reducing risk in the already risky high-yield bonds market.
Here are three that fit the bill.
High-Yield Bond Funds: Vanguard High-Yield Corporate Fund Investor Shares (VWEHX)
Expenses: 0.23%, or $23 per $10,000 invested
Vanguard High-Yield Corporate Fund Investor Shares (VWEHX) is among the best of the high yielding bond funds. This fund holds high-yielding bonds with an average maturity of 5.4 years and an SEC yield of 5.4%. Among the fund’s holdings are Softbank Corp (SFTBY) bonds, Sprint Corp (S) bonds and Royal Bank of Scotland Group PLC (RBS) bonds.
What is unique about this high-yield bond fund is that most of its bonds are rated between Aaa and Baa3, rather than junk rating. This allows VWEHX to obtain a high yield but reduce the risk of default on one of its bond holdings.
While this strategy might produce fewer gains when high-yield bonds are booming, it also outperforms when high-yield bonds are out of favor, thus providing important protection to your downside.
VWEHX top sectors include consumer non-cyclical, communication and finance.
VWEHX does have an 8.9% exposure to the more risky energy sector, but with oil prices stabilizing, energy junk bonds are making a comeback and tend to benefit the fund. Moreover, the exposure to that sector is still relatively low.
High-Yield Bond Funds: PIMCO 0-5 Year High Yield Corporate Bond Index (HYS)
The PIMCO 0-5 Year High Yield Corporate Bond Index (HYS) is another well-managed fund worth owning. HYS ETF tracks the BofA Merrill Lynch 0-5 Year US High Yield Constrained Index, and currently has an SEC yield of 5.9%.
Among its major holdings are Telecom Italia Cap bonds, Softbank bonds and plenty of credit derivatives. The way HYS reduces the risk of its high-yield bonds is by hedging with credit derivatives and focusing on bonds with short maturities
One of the big risks inherent in high-yield bonds is that their price falls significantly when risk aversion dominates. Then, investors are forced to sell the bonds at a significant discount and, as a result, lose all the benefits of its high interest. But since HYS has primarily short maturities with an average maturity of 3.3 years, then HYS can hold bonds until maturity and reduce the downside.
Among the fund’s top holding sectors are healthcare, mining and consumer finance. Energy is not among the top holdings of the fund, yet it still reported that its energy-related high-yield bonds outperformed and gained.
High-Yield Bond Funds: Market Vectors Fallen Angel High Yield Bond (ANGL)
Market Vectors Fallen Angel High Yield Bond (ANGL) tracks the BofA Merrill Lynch US Fallen Angel High Yield Index. ANGL’s edge is by investing in what they call “fallen angels” — that is, high-yield bonds that were once rated as investment grade and were later downgraded.
The logic behind this approach is that companies which were once considered “investment grade” and which are now rated as “junk” tend to have much stronger cash flows than those that began as junk bonds. As a result, their high-yield bonds tend to be safer and outperform.
This fallen angel strategy has thus far worked tremendously well, with the ANGL ETF Net Asset Value gaining roughly 12% year to date compared to the benchmark Barclays US Aggregate Bond TR index, which gained 3%.
Among ANGL fund’s top holdings are Abn Amro bonds, Sallie Mae (SLM) bonds and Southwestern Energy Company (SWN) bonds. The fund-weighted duration is 13 years with an SEC yield of 5.98%.
It should be noted that while ANGL’s “fallen angels” method reduces risk of default by an emphasis on stronger cash flow, the fund’s price has a tendency to be volatile. ANGL is considered riskier than the other two funds and, hence, should be given less weight.
As of this writing, Lior Alkalay did not hold a position in any of the aforementioned securities.