This is the second in a series of five articles looking at the most popular bond alternatives and the safest ways to use them to improve your income prospects when rates are low. Adapted from “Reaching for Yield” in the January/February issue of Money magazine.
Falling oil prices have really pummeled the high-yield bond universe, where energy issues make up 15% of the market. Worried that these developments raise the risk of defaults for junk—issues rated BB+ or lower —investors have been selling their bonds. That has driven yields up sharply as new buyers demand higher payments to offset greater risk.
That’s a big change from last year, when you might as well have called these securities the “bonds formerly known as high yield.” Halfway through 2014, amid high demand, junk was paying just 3.4 percentage points more than Treasury securities of similar duration—well below the long-term average premium of 5.8 points and a world away from the yawning 20-point gap during the financial crisis in late 2008.
Now the yield gap is back near the norm. “The spreads are close to fair value,” says Marty Fridson, chief investment officer at Lehmann Livian Fridson Advisors. Fridson believes the fall in oil will turn out to be a positive for junk investors: “Eventually the economy will benefit from lower oil prices, which will help the 85% of high-yield bonds not in the energy sector.”
Stay away from the junkiest junk, though, where yields aren’t good enough to justify the higher default risk, says Gershon Distenfeld, director of high yield at AllianceBernstein. According to Standard & Poor’s, 65% of issues rated CCC to C historically have defaulted within five years, compared with 3.4% for BB-rated bonds. Sure, the C’s yield a lot more—11.3%, vs. 5% for BB’s—but that won’t matter if the issuer stops making payments.
Your best strategy: Focus on funds that overweight bonds rated BB+ through B, which are still paying roughly twice as much as Treasuries. Jeff Tjornehoj, head of Lipper Americas Research, calls USAA High Income Fund “a stellar performer” because of its ability to manage risk while still providing high returns. The fund was recently yielding about 6% and has only 8% of its holdings in C-rated bonds. Morningstar analyst Sarah Bush also praises the conservatism of Vanguard High-Yield Corporate , yielding 6%. The fund has 93% of its portfolio in bonds rated B or better and a razor-thin expense ratio of 0.23%.
More in this series:
The Smart Way to Invest in Dividend Stocks